What is Book-To-Market Ratio?
A book-to-market ratio is a mathematical comparison of a company's actual value to its market value. The actual value of a company is determined by internal accounting, and its market value is its market capitalization. Generally, the result of this comparison can be used by market analysts to determine if a company is overvalued or undervalued. Analysts can then evaluate the company's common stock as a potential investment, which will often result in public upgrades or downgrades of that stock.
Calculating a book-to-market ratio is done by dividing the company's book value by its market value. The book value must be obtained from the company and can usually be derived from the earnings announcements that most companies perform every three months. Generally, the market value is equal to the company's market capitalization, which can be calculated by multiplying the price of its stock by the total shares of stock that it has issued.
A book-to-market ratio greater than one indicates that the company may be undervalued and many investors will take this as a sign that it is a good investment. This is because obtaining a ratio greater than one requires the book value to exceed the market value, which may indicate that investors have not given the company the credit it deserves. Similarly, a book-to-market ratio less than one indicates that the company may be overvalued, and many investors will take this as a sign that it may be time to cash in their shares of stock. The reasoning here is that for the ratio to be less than one, the company's market value has to have exceeded its book value, meaning the investing public has perhaps given the company too much credit.
Earnings announcements can create opportunities for investors because they cause adjustments in book-to-market ratios. When a company announces its earnings, those earnings are added to its previous book value, causing the book-to-market ratio to increase. Normally, investors will take an increasing ratio to mean a company is doing well and may be worth investing in. This further investment increases the company's market value and brings the ratio closer to a value of one once again.
One historical problem with using book-to-market ratio as an investment guide is that certain companies have been known for dishonest accounting. Instances of dishonest accounting create artificially high book-to-market ratios that attract investors. When the real book value of a company that does this is finally revealed, the book-to-market ratio, followed by the company's stock price, invariably plummets.
@miriam98 - I feel sorry for you; lesson learned I suppose. If it’s any consolation, that drama got played out over and over again in the late 1990s, during the Internet bubble. People were paying for stocks with high PE ratios. There was no way those stocks could sustain those valuations. Everyone was drinking the “Kool-aid,” so to speak, ignoring the warning signs. What followed next is history of course.
@NathanG - Investors tend to be a skittish bunch. When I first got started investing I was advised by a friend not to make any stock purchases right before an earnings announcement. He said that with such news stock prices could swing wildly in either direction.
Well, I ignored his advice. I put my money in a company that had been doing well for twelve months, and all the analysts were saying the sky is the limit. The charts were looking favorable, good weather was on the horizon – so it seemed.
You’ll never believe what happened. After making my purchase the stock took a nosedive – I mean, it fell like a rock. The news announcements said the company’s products were doing well, but had been hit by thin margins because of pressures from the competition.
Investors fled like crazy, and I was left with a portion of my investment, licking my wounds, when it was all over.
@David09 - I am a value investor myself. I always look for stocks that are priced well below the market’s assessment. I do this by following analyst opinions on the stock and also using online tools.
With these tools I can apply filters for companies that have a reasonable price earning ratio. As a result I get what are high quality investments, at least from what I can tell.
I also like to focus on companies that pay dividends as these tend to be stable over time. Now these are not the high flying companies of the Internet bubble but they do grow slowly over time.
I concur that dishonest practices can affect the book to market ratio of a company and cause its stock prices to plummet.
That's why you need to be careful when investing. The stock share price alone is not really an accurate reflection of how well the company is doing, not by a long shot.
I worked for a major telecommunications company up until 2001, after it was revealed that the CEO had cooked the books so to speak and the stock of the company subsequently took a nosedive. The SEC came down really hard and the company eventually filed for bankruptcy.
I understand why the books were cooked however. Internal accounting revealed that the company was not doing well as its stock price dictated and so money was shuffled and moved around until it appeared that it was. Still, that’s no excuse for criminal behavior.
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