As investors, we strive to grow the value of our “financial garden”, with that “garden” being a portfolio holding our various investments. There are many tools we can use to achieve this. Some methods emphasize the income generated from the investment such as buying real estate for rental income. Other methods of investing emphasize increasing the underlying value of the investment itself, such as buying real estate with the aim of selling later at a profit. The underlying value of an investment is known as “net worth”.
What is Net Worth?
The “Net Worth” of an investment is equal to “assets minus liabilities”. Another name for this is called “equity” which we use to track the underlying value of an investment. As an investment value grows, the Net Worth of that investment increases over time. We then use the Net Worth to arrive at “Book Value”. For Example:
Asset – Liabilities = Equity or Net Worth
$1,000,000 – $400,000 = $600,000
“Equity” divided by “Shares Outstanding” = “Book Value”
$600,000 divided by $1,000,000 = $0.60 or 60 cents per share
NB. “Shares Outstanding” is the total number of existing common shares
What is Book Value?
Book Value is the underlying net worth of the investment expressed per share. In contrast, the price signals how buyers and sellers view an investment at a given point in time. Hence, the price of an investment and the book value of an investment are not always equal. When book value is higher than the price, it is undervalued and we are paying a discount. When the price is above book value, it is overvalued and we are paying a premium. We compare the difference by looking at the ‘Price to Book Value Ratio’ which is the price divided by the book value.
Which provides more value for an investor?
Business A has a lower “Price to Book Value” ratio than Business B. This means that the Price of Business A is closer to “Book Value”, hence, we are getting a better bargain than in the case of Business B.
Business B looks cheaper at $5, but Business A at $20 provides better value for money when book value is considered. Sometimes we only focus on price as investors, but the book value guides us in knowing if we are paying too much or too little for the investment.