Book value of a company is the difference between a company’s asset and liabilities, which, in other words, is shareholders equity. Book value is the net of what the company owns (assets like land, buildings, machinery etc.) reduced by what it owes (liabilities like loans).
When we divide book value by the number of shares outstanding, we get book value per share (BVPS). In mathematical terms, Book Value per Share = Total Shareholder’s Equity ÷ No of Shares.
This ratio is used by investors to compare BVPS with the market price of the company. If BVPS is more than the market price, the company’s stock is said to be trading at a discount, whereas if BVPS is less than the market price, the stock of the company is said to be trading at a premium.
BVPS > Market Price = Stock trading at a discount
BVPS < Market Price = Stock trading at a premium
Let’s take an example of IDFC. The total equity which also equals the net worth is as follows:
Equity (as on 30/09/2014): Rs. 1,590 crore
Reserves and Surplus (consolidated, as on 30/09/2014): Rs. 15,354 crore
Outstanding Equity Shares: 159.03 crores
Book Value Per Share (BVPS) of IDFC = (Equity + R&S) ÷ No of Shares = (Rs 1,590 crore + Rs. 15,354 crore) ÷ 159.03 crores = Rs 106.55.
Comparing this book value of Rs 102 per share with the market price (as at 16th December 2014) of Rs 151, we can say that the stock is trading at a premium of 42%
BVPS method of valuation, however, lacks on the following counts:
- The assets in the balance sheet may not be properly valued. For example, if the company bought land worth Rs. 5 crore in 1994, even 20 years later in 2014, land will be shown at Rs. 5 crore only in the balance sheet. But in reality the asset value might be much more than that. Book value does not reflect such increase in value.
- Plant and machinery are shown at cost less depreciation. However, such plant may have depreciated much more, if it has become technologically obsolete. Hence the plant and machinery may not fetch the value shown in the balance sheet.
- The liabilities side of the balance sheet may also not be correctly reflected. Contingent liabilities are not included in the calculation of book value. Also, adequacy of provisions, if any, is a subjective estimate in many cases.