Financial Reporting – Market/Book Values
November 14, 2009 Leave a comment
Some things that are identical have different values.
An empty tin of dog food is worth about $0.10. An empty tin of Paris Hilton’s dog food went on ebay for $305.
I think the message here is that most people are crazy, but there is probably some sort of deeper meaning too. If you manage to work out what it is, please let me know.
Note: That was the first and last time Paris Hilton will ever be mentioned on this website
- A company’s market value is how much the stock market estimates the company is worth
- The total market value is:
Market value = Value per share × number of ordinary shares in the market
- Note: May also be called market capitalisation
What determines market value of a share?
- Supply and demand
- Traders looks at the expected future cash flows in the form of dividends, which are paid out of profits
- Events that are likely to affect future profits will therefore affect share prices
- The book value of a business is what describes it’s net asset value
- Looking at the balance sheet equation, this means that net asset value is:
Total assets – Liabilities
- To calculate book value per share, divide the book value by the number of ordinary shares issued
Market / Book ratio
market value ÷ book value
Sometimes called the PB (price to book) ratio
Sometimes it is calculated the other way round so watch out. But that won’t happen in the exam (allegedly)
Value of the ratio
- The ratio is a value from within the company’s accounts and a value generated externally
- It will either be less than 1 or greater than 1
Less than 1
- If the ratio is less than 1 then the shares might be undervalued
- However it is more likely that the company is doing badly, which has been factored into the market price, lowering it
More than 1
- More likely to happen
- It could mean the shares are overvalued but probably not. There are several over reasons though:
- Book values are based on accounting concepts and methods
- Accruals, prudence concepts lead to depreciation of non-current assets, provisions and write-downs
- Often based on rules of thumb
- The historic cost concept means that book asset values will not equal market values:
- non current assets
- debtors (trade receivables)
- Intangibles and goodwill cannot be quantified
- Market values are based on the future, book values are based on the past
Service businesses should really show a gap between their book and market value, as they have more intangibles.
Capital intensive businesses should be the opposite as their assets are financial and are easier to value