GRINMOR TECH INC.

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.

It’s enough for our purposes, here, to observe that book value is a company’s assessment of its own equity: determined by subtracting the value of total liabilities from the value of total assets. The value of that equity though is determined differently on the market: it generally responds to the shifts in demand, since it is rare for new shares to be issued. (Further detail on how these values are calculated can be found through the link at the end of this article.)

The book value of the company will be a more stable price. However, if it is subject to sound accounting practices, it too will change with the passage of time. An obvious example would be in the case of the depreciation of infrastructure. Stock market prices, though, as we all know, do not reflect such stability or orderly gradated adjustment. Instead, they fluctuate – and often far and fast.

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.

Putting those reasons aside, just briefly, the basic principle involved is simply that the market – by which, of course, we mean the buyers and sellers of companies’ shares, through constant bid-ask operations – hits upon prices disputing the equity value that the company assigns its own capitalization.

The difference may be of course either more or less than book value. The potential reasons for the discrepancy may be any of many. It can be as simple a matter as brand recognition and estimation. Should a particular brand have a high enough cache or reputation with the relevant consumer base, virtually identical products may be differently valued in the market, allowing the stronger brand to successfully charge more.

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.

Many discrepancies, however, are indeed a function of markets disagreeing with the stated book value of a company’s assets. An example would be the situation in which a company’s assets include undeveloped land. If the market, and the company’s accountants, has valued the assets at prevailing real estate rates a potentially dramatic divergence of value could result if enough share traders re-evaluate the land. Say, for instance, they become convinced that the region in question is poised for a major real estate boom. At that point traders may now consider the land a significantly undervalued asset on the company’s books.

Recognizing such undervalued shares sufficiently in advance is a means to great profits. Those who have early enough recognized the situation bid on the company’s shares in great numbers. The more shares one can purchase at the undervalued price the more total profit one stands to make whether the long term intent is to resell at the higher price or collect the increased dividends expected. In the process, of course, this raised demand for the shares pushes up their price. The resulting market capitalization value is thus increased considerably over 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.

As we’ve seen, then, numerous potential reasons may lie behind the discrepancy between book and market value. In all cases, though, this discrepancy reflects the judgment of a large-enough number of traders that the company’s actual value is not accurately reflected in its book value. For the successful investor, early recognition of such a situation and sound assessment of its validity is the key to successful investment strategy, leveraging market capitalization against book value.

The illustrations above provide plenty of different manners in which diverse skills and insights can aid in such leveraging: e.g., familiarity with the real estate market, the government’s legislative agenda or popular taste. Possessing insight into any of these matters, or numerous others, can provide the opportunity to benefit from a book value that inadequately appreciates the true or immanent value of a company’s equity. When you discover such a discrepancy the opportunity for profitable investment – whether under or overvalued – is available.

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.

Investors who want to leverage profits from mistakenly valued book equity need to follow all the hottest tips at the Market Capitalization blog. Wallace Eddington is an insightful commentator on markets and finance. His recent article on fiat currency and inflation is a must read for those looking to make sound monetary investments.