Book value per share (BVPS) is one of the most commonly used valuation metrics to assess a firm’s accounting value based on shareholder equity. Put simply BVPS represents the amount that you will receive as a shareholder, should the company dissolve, but keep in mind that a firm’s balance sheet may not reflect in complete accuracy what would actually occur if the firm did sell all of its assets.
Understanding how BVPS works
Book value per share is calculated by dividing common equity by the number of shares outstanding. Therefore:
BVPS = Common equity / Number of shares outstanding
Investors use book value per share to determine if a stock is overvalued, undervalued or fairly valued. This is because BVPS uses the number of shares outstanding as a denominator, thereby lowering or increasing the equity value per share. So, if a firm can increase its BVPS, it would signal that the stock is more valuable, thereby pushing the stock price up.
When a stock is overvalued, the stock price is higher than the present value, signaling that the stock has been already expensive and you should probably sell it as it is unlikely that it will rise further. When a stock is undervalued, the stock price is lower than the present value, suggesting that the stock has room for growth, and you should probably buy it.
Value investing is a time tested stock picking strategy that focuses on the intrinsic value of stocks, and more specifically, on undervalued stocks… because these have the potential to rise.
If you are already familiar with value investing, you know that the market assimilates newly available information, pushing the stock price up or down, even if a price change does not correspond to the firm’s fundamentals. But, this is how a profitable investment opportunity arises. This is also where the BVPS comes into the picture.
Benjamin Graham, the father of value investing, has come up with what is known as “margin of safety” when investing in undervalued stocks. Margin of safety is basically the discount on the stock price relative to its intrinsic value. In fact, Graham designed a simple, yet comprehensive stock selection model, so that investors can calculate the intrinsic value of a stock and select undervalued stocks with a growth potential.
The formula is known as the Graham number, and it represents the maximum price that you should pay for a stock according to its earnings per share (EPS) and book value per share (BVPS). In other words, if the Graham Number (the present value) is higher than the market price, the stock is undervalued and vice versa. The formula to calculate the Graham Number is SQRT (22.5 x EPS x BVPS).
Consider this example:
Here are three large caps trading in different industries. However, all three are well-established companies with high-quality management and a great line of products. Due to their brand name, popularity and strong financials, these stocks are attracting more investors. Investor confidence rises when a firm is financially solvent, thereby pushing the stock up.
Question: Do current prices reflect the true value of these stocks?
Here is the answer:
According to the Graham number, Coca-Cola (NYSE: KO) and Exxon Mobil (NYSE: XOM) are significantly overvalued, trading by more than 180% over their intrinsic value. Would you sell them? Probably. Or maybe not. They have remarkable debt-to-equity ratios, both below 1, and after all, they are strong companies. Gilead (Nasdaq: GILD), on the other hand, is undervalued by almost 72%, indicating an opportunity to buy.
The Role of P/B Ratio when Valuing Stocks
Price to book (P/B) is used to compare a firm’s book value to share price. A company that trades at a low P/B, especially when compared to peer companies, is most likely undervalued. In the above example, notice the P/B ratios of the companies.
Gilead has a P/B ratio of 6.30. How does this compare with the industry average? The industry average P/B ratio for the biotechnology sector is 23.45, so Gilead has a lower P/B ratio. The next thing to consider is the EPS. Gilead has an EPS of $11.35.
The higher the EPS, the more likely is that the stock trades under its intrinsic value. For example, both Coca-Cola and Exxon Mobil have a low EPS ratio, thereby being overvalued when EPS is used in the Graham number calculation.
Another thing to consider is the DPS (dividend per share). Companies that have consistently declared dividend payments and/or raise their dividends are financially healthy companies and investors generally trust them. So, it’s not surprising that Coca-Cola or Exxon Mobil are overvalued. Investors trust them.
Where Can You Find Value Stocks?
Seeking undervalued stocks is essentially trying to buy a stock with good earnings at the lowest possible price. Stocks prices change intraday, and you cannot know for sure when an undervalued stock will appreciate. However, a company’s earnings are fairly straightforward. This is why you should also consider EPS when gauging the relative value of a stock.
Value stocks can be located in any industry, however, the rule of thumb is that you can trace them in industries that incur sharp fluctuations, thereby pushing the stock prices low and causing appreciation.
An example is the manufacturing industry, which is slowly improving due to export growth as a result of a weaker dollar. Alternatively, value stocks trade in industries that are affected by great developments, so they tend to appreciate, at least in the short-term.
Such an example is the auto manufacturing or the technology industry. On the other hand, a poor BVPS can insinuate a bad investment. Stocks with poor financials and low BVPS are raising a red flag as to whether you can realize any profit at all.
Check out this table:
Stocks like Emerson Electric Co. (NYSE: EMR) or Cummins Inc. (NYSE: CMI) can make up for a great investment because they combine solid earnings, high dividends, and great BVPS ratios. General Electric has a great BVPS, yet you should also consider the fact that its total assets are lower YoY by 24.72%.
On the upside, long term debt is also lowered by 22.65% YoY. Ford is undervalued, has a relatively high BVPS, but it has also increased its assets YoY by 7.82%. On the downside, it has also increased its long-term debt by 12.32%. Finally, Microsoft has a high BVPS, has increased its assets and its long-term debt, whereas Oracle has also increased its assets but has a poor BVPS.
The bottom line is that when researching value stocks, you have to delve deeper into the company’s financials to gain a better understanding of the company. In some cases, earnings may go to the expansion of operations rather than increasing shareholder value through dividend payments.
So, go to the company’s balance sheet, check out the BVPS, investigate changes in total assets and long-term debt, and evaluate the short-term potential before seeking the long-term growth.
No stock is ever 100% secure but the higher the book value, the greater chance you have for big profits. As a value investor, you are seeking long-term growth. However, you can take advantage of short-term market fluctuations to load up on shares of high-quality dividend growth businesses for as low as possible.