The difference between book and market capitalization and how it is calculated is a matter I've addressed elsewhere. Space constraints prevent repeating the explanation at any length.
Suffice it for now to say that the book price is the value that a company's accountants and executives attach to its equity - derived by total liabilities subtracted from total assets. The market price is the valuation that traders in the company's shares arrive at through the market exchange process. (For more detail on how these numbers are derived, see the link at the bottom of this article.)
Relatively speaking, book value is stable. That, though, doesn't mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.
Discussion of this constant movement of stock prices will have to wait for another occasion. Here we only want to understand the reason for the discrepancies between book and market capitalization and the relevance of that difference to investing.
Leaving aside for a moment the reasons, which may be many, the simple explanation is that the market - which is to say those who partake in the buying and selling of companies' shares, via their bid-ask interactions - have arrived at a price which values the equity differently than the value determined by the company itself.
The market capitalization may be more or less than the book value. There are plenty of potential reasons for this. Sometimes it is merely a matter of brand. If, for whatever reason, the company brand is highly regarded, product Y produced by it may simply be more highly valued by consumers than a Y produced by a company with a lesser brand.
If this results in consumers willing to pay a brand premium for the product, capital otherwise hardly distinguishable from competitors effectively becomes more valuable. In such situations, obviously, there is no dispute about the literal book value of the company's assets. Nonetheless, though, further considerations may lead share traders to value the shares more than suggested by the book value.
Other discrepancies may arise though from disputing the book value. Say a company has among its assets undeveloped land that the market, like the accountants, has valued in its equity calculation at the going real estate rates. However, should a large enough subset of share traders believe - for whatever reason - that the region in which this land is located is on the verge of a major real estate boom, they would consider the current asking price for the company's share to be undervalued.
Such undervalued shares are tickets to windfall profits. Those traders convinced of the coming real estate boom thus seek to buy the shares in great numbers, increasing demand for the shares and bidding up their price. The result is a market capitalization value greater than the book value.
It can likewise work the other way around. If the company is in a business which a large enough number of share traders become convinced will soon be subject to new, onerous regulation that will entail massive compliance costs, their conclusions could be that the company's book value of its equity insufficiently accounts for its actual liabilities. The shares are considered overpriced and shareholders start lowering prices to unload them and cut their losses.
Thus, though there are numerous potential explanations, the discrepancy between book and market valuing of a company's capitalization reflects the market's doubt about the company's book value. Understanding what this doubt is and whether it is soundly based is the key to an investment strategy that leverages market capitalization against book value.
As seen in the examples above, there are a variety of skills and insights one might bring to bear in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Whatever your own edge, if you can recognize where the market valuing of a company's capitalization fails to adequately appreciate the true or immanent, as opposed to book, value of a company's assets, the opportunity for profitable investment - whether buying or selling - has presented itself.
It is in this way that knowledge of the difference between book value and the market capitalization unlocks vital investment opportunities. If this discussion presumes knowledge about market capitalization with which you don't feel quite up to speed, I'd suggest having a look at my What is Market Capitalization article.
Suffice it for now to say that the book price is the value that a company's accountants and executives attach to its equity - derived by total liabilities subtracted from total assets. The market price is the valuation that traders in the company's shares arrive at through the market exchange process. (For more detail on how these numbers are derived, see the link at the bottom of this article.)
Relatively speaking, book value is stable. That, though, doesn't mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.
Discussion of this constant movement of stock prices will have to wait for another occasion. Here we only want to understand the reason for the discrepancies between book and market capitalization and the relevance of that difference to investing.
Leaving aside for a moment the reasons, which may be many, the simple explanation is that the market - which is to say those who partake in the buying and selling of companies' shares, via their bid-ask interactions - have arrived at a price which values the equity differently than the value determined by the company itself.
The market capitalization may be more or less than the book value. There are plenty of potential reasons for this. Sometimes it is merely a matter of brand. If, for whatever reason, the company brand is highly regarded, product Y produced by it may simply be more highly valued by consumers than a Y produced by a company with a lesser brand.
If this results in consumers willing to pay a brand premium for the product, capital otherwise hardly distinguishable from competitors effectively becomes more valuable. In such situations, obviously, there is no dispute about the literal book value of the company's assets. Nonetheless, though, further considerations may lead share traders to value the shares more than suggested by the book value.
Other discrepancies may arise though from disputing the book value. Say a company has among its assets undeveloped land that the market, like the accountants, has valued in its equity calculation at the going real estate rates. However, should a large enough subset of share traders believe - for whatever reason - that the region in which this land is located is on the verge of a major real estate boom, they would consider the current asking price for the company's share to be undervalued.
Such undervalued shares are tickets to windfall profits. Those traders convinced of the coming real estate boom thus seek to buy the shares in great numbers, increasing demand for the shares and bidding up their price. The result is a market capitalization value greater than the book value.
It can likewise work the other way around. If the company is in a business which a large enough number of share traders become convinced will soon be subject to new, onerous regulation that will entail massive compliance costs, their conclusions could be that the company's book value of its equity insufficiently accounts for its actual liabilities. The shares are considered overpriced and shareholders start lowering prices to unload them and cut their losses.
Thus, though there are numerous potential explanations, the discrepancy between book and market valuing of a company's capitalization reflects the market's doubt about the company's book value. Understanding what this doubt is and whether it is soundly based is the key to an investment strategy that leverages market capitalization against book value.
As seen in the examples above, there are a variety of skills and insights one might bring to bear in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Whatever your own edge, if you can recognize where the market valuing of a company's capitalization fails to adequately appreciate the true or immanent, as opposed to book, value of a company's assets, the opportunity for profitable investment - whether buying or selling - has presented itself.
It is in this way that knowledge of the difference between book value and the market capitalization unlocks vital investment opportunities. If this discussion presumes knowledge about market capitalization with which you don't feel quite up to speed, I'd suggest having a look at my What is Market Capitalization article.
About the Author:
Investors who want to benefit from misvalued book equity should be keeping up with the hottest scoop at the Market Capitalization site. Wallace Eddington is an insightful commentator on markets and finance. His recent piece on fiat currency and inflation is required reading for those looking to make sound monetary investments.
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