Book value vs. market value: Knowing the difference between these two measures can help investors pick stocks

• Book value and market value are ways to evaluate a company. Book value is based on its balance sheet; market value on its share price.
• If book value is higher than market value, it suggests an undervalued stock. If the book value is lower, it can mean an overvalued stock.
• Book value and market value are best used in tandem when making investment decisions.

Among the many measures that investors can evaluate companies, two tools are especially popular: book value and market value.

Aside from the word "value" in their names, though, the pair have little in common.

One is an objective approach that encompasses balance sheets and financial statements - a company's books. The other is a more subjective approach, which takes into account the sometimes irrational sentiments of the stock market.

Despite these differences, or because of them, investors often set a company's book value and market value against each other to determine if the shares are overpriced or underpriced - and so whether the stock's a good deal or not.

Let's compare the two metrics more closely.

What is book value?

Book value can be looked at basically as a company's break-up value - the amount that the company would be worth if it were liquidated.

Calculated from a company's balance sheet, it takes all the company's assets - physical things of value, from inventory and investments to equipment and real estate. It then subtracts intangible assets (copyrights, patents, intellectual property) and liabilities (like loans, taxes, and other debts).

The formula for book value is:

Book Value = Total Assets - Intangible Assets - Liabilities

Let's say a company had total assets of $20 million, of which $5 million were intangible assets. Let's also say a company had liabilities of $8 million. The book value of the company would be $7 million: $20 million - $5 million - $8 million.

Book value is best used with companies that have significant physical assets, such as manufacturers that own factories and plants, heavy machinery, and other equipment. It doesn't work as accurately for companies whose assets are primarily intangible assets, such as info-technology or digital firms, whose assets lie primarily in intellectual property - their formulas, systems, algorithms, etc.

Book value alone is just a reflection of a company's equity - what it owns.To be used as an decision-making tool, it needs to be compared to a company's market value before an investor can determine whether to buy or sell a stock.

What is market value?

Market value is also known as market capitalization, is the value of all of a company's stock in the marketplace. It's what it would cost you if you were to buy up every one of its outstanding shares at the current share price.

It can be calculated by multiplying the share price by the total number of shares that are trading.

The formula for market value is:

Market Value = Current Market Price Per Share x Total Shares Outstanding

For example, if the current stock price of Company ABC is $105 and the company has 80 million shares outstanding, its market value is $8.4 billion: $105 x 80 million.

Market value can be a volatile figure. It changes throughout the day because a company's share price constantly fluctuates, as investors and traders buy and sell the stock.

For the most part, though, the number doesn't change very drastically; it only happens if there is significant good news or bad news related to the company or to the industry in which it operates. Total shares outstanding almost never changes, only on rare occasions when company's enact stock buybacks or issue more shares of stock.

Book value vs. market value

The key differences between book value and market value include:

• What they're based on. Book value is a valuation of a company that takes into consideration hard financial figures: actual assets and liabilities. Market value is the valuation of a company based on its share price. Yes, that's a number, but it's a figure that fluctuates based on investor perceptions of the company, including such intangibles as proprietary software, artificial intelligence algorhythms, and future growth prospects. It is a way of sizing up a company by the value that investors put on it.
• How up-to-date they are. One of the drawbacks of book value is that it can only be determined from a company's financial statements. As companies usually only report financial statements quarterly or annually, book value is not a readily available number and it is, therefore, a number that can change from one reporting period to the next without any insight into the interim period. Market value on the other hand is available every day throughout the day.
• How understandable/accessible they are. Book value can be difficult to ascertain unless an investor makes an effort to understand how a company's accounting practices work: the type of depreciation used on assets, any claims on assets, and how creditors might sell them in liquidation. Book valuation can be subject to various accounting practices and tax law that can result in it being an adjustable figure. In contrast, market value is pretty transparent and easy to find - market cap figures for companies are typically a part of online stock listings and corporate profiles.
• How accurate they are. Of course, figures can be manipulated, and value is to some extent in the eye of the beholder. Still, assuming everything is accurately reported, book value is an insightful number that can be an indicator of its financial health. But the market value of a company is one based on perception and is, therefore, not necessarily an accurate representation of its value. A company's stock price may be inflated or deflated for a variety of reasons, such as the announcement of an acquisition, a new product, or a lawsuit, without any real understanding of the true impact or ramifications of these events. The history of finance is strewn with companies and sectors, like dotcom stocks in 2000, that inflate in speculative bubbles based on news and rumors, only to come crashing down when investors realize their market value did not equate to their actual financial standing.

Comparing book value and market value

You don't have to choose between using book value and market value. The real advantage for investors lies in comparing these values to one another for a specific company.

If book value is higher than market value, it can mean an undervalued stock. If the book value is lower, it can mean an overvalued stock.

So if the book value of a company is higher than its market value, it means that investors are not factoring in its actual financial fundamentals - the strength of its operations and balance sheet. It can mean a good opportunity to purchase a company's stock as its share price will most likely appreciate, once the market realizes the company's intrinsic strength.

Conversely, if a company's market value is higher than its book value, it most often indicates a company that is overpriced, and whose actual worth does not live up to its perceived worth. This would be a good time to sell the stock or avoid buying it as most likely there will be a market correction, causing the share price to drop.

If a company's market value is above its book value but starts to fall to eventually below its book value, it could indicate a loss of investor confidence in the company that has not yet been factored into its book value.

The financial takeaway

Book value and market value are two ways to value a company. Book value is based on a company's balance sheet while market value is based on a company's share price, which changes often due to stock market sentiment.

Book value represents the financial strength of a company based on its assets, an objective number. In contrast, market value represents the attractiveness of a company's share in the marketplace, a somewhat more subjective number.

Investors should use book value and market value in tandem when making investment decisions. Of course, just looking at the figures isn't enough. An investor needs to understand the rationale behind the numbers to make an educated stock pick.

Related Coverage in Investing:

The price-to-book ratio is a way to determine if a company's stock price accurately reflects its financial value

What is the P/E ratio? An analytical tool that helps you decide if a stock is a good buy at its current price

What is a large-cap stock? It represents a $10 billion-plus company - and often low-risk, stable returns for investors

What is a mid-cap stock? It means a company worth $2 to $10 billion - and often an ideal balance between growth and income for investors

What is a small-cap stock? A company worth under $2 billion with massive growth potential for investors