Western Union. PhillipMorris. DirecTV. Hershey. Colgate.
As diverse as these companies are, they have two things in common: Historically, their businesses have been highly-valued by Wall Street. Second, they’ve all dominated the market.
When I say their businesses are "highly valued" by Wall Street, you might point out that these companies don’t have anywhere near the market capitalization of ExxonMobil, Apple or Walmart.
And you'd be right, but you'd also be missing a very important difference.
Market Cap vs. Value of a Business
You see, market cap is merely how the market values the company. What we’re talking about is the value of the underlying business.
While you might think that calculating this number requires a lot of skill and effort, you’d be mistaken.
How to Calculate Book Value from a Balance Sheet
Look at any company balance sheet (which is a snapshot of the company's finances). The assets are listed first, followed by the company's liabilities. The difference between them is "shareholder equity," which is the part of the company that investors actually own. This is no different than the equity you have in your home, but in a company, it’s known as book value.
Sometimes it's broken down to the per-share level, other times it's left in the large-number format. In any case, the price-to-book ratio can be calculated in one of two ways:
Dividing a company's market value by its equity
Dividing its share price by its per-share book value.
Calculating Book Value Example #1: Big Numbers
Say that Hewlett-Packard (NYSE: HPQ) is worth $86.7 billion. On Google Finance, we see that their balance sheet shows equity of $42.5 billion. In our equation, the market value is $86.7 billion which we divide by the $42.5 billion shareholder equity line. HP is trading at 2.0 times book value.
Calculating Book Value Example #2: Per-Share Data
Say that Medtronic (NYSE: MDT) closed at $33.34. Yahoo Finance provided a per-share book value of $13.52. We enter our numbers as: $33.34/$13.52 = 2.5 times book value.
What These Numbers Mean
Both Hewlett-Packard and Medtronic traded at a slight premium to the S&P 500 Index (which trades at an aggregate 1.94 times book value).
Any dollar of market capitalization in excess of shareholder equity is the market's value on the company's underlying business. An enterprise is more than just the net value of its desks, buildings, inventory, and other assets.
The higher the price-to-book ratio, the stronger Wall Street's faith in the underlying business' ability to make continued profits.
What Does a Company’s Book Value Tell You?
We analyzed 491 companies in the S&P with a price-to-book ratio of greater than 0. The top four highest-returning companies mostly had price-to-book values far in excess of the average:
Conversely -- Remember to always invert your list! -- the four worst performers had lower price-to-book multiples:
Understanding Book Value Is Crucial for Top Investors
All investors should understand book value, where it comes from, how to calculate it, and the appropriate way to contextualize the data. Long-term growth in equity is a key trend to watch for. In fact, it's one of super-investor Warren Buffett's favorites – and it's also the way he evaluates his own performance as the chief executive of Berkshire Hathaway.
Conservative investors may elect to add a minimum or maximum price-to-book criteria to their investment requirements. The sweet spot seems to be a price-to-book ratio of between 4.5 and 5.0. Of the 12 companies that meet that, 10 have beaten the S&P (with a handsome average of +19.4%). Not only does this beat the negative showing of the broader market year-to-date, but it also beats the long-term historical average gain.
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