Primary aim of management is to increase the book value and the market value of the company.

The primary aim of management is to increase

• the book value and 
• market value of the company.

Book Value

Book value (shareholders' equity on the company's balance sheet) is calculated as total assets less total liabilities.

It reflects the historical operating and financing decisions made by the company.

Management can directly influence book value (e.g., by retaining net income).


Market Value

However, management can only indirectly influence a company's market value.

Market value of a company is primarily determined by investors' expectations about the about, timing and uncertainty of the company's future cash flows

A company may increase its book value by retaining net income, but it will only have a positive effect on the company's market value if investors expect the company to invest its retained earnings in profitable growth opportunities.

If investors believe that the company has a significant number of cash flow generating investment opportunities coming through, the market value of the company's equity will exceed its book value.



Price to book ratio (market to book ratio)

A useful ratio to evaluate investor's expectations about a company is the price to book ratio.

If a company has a price to book ratio that is greater than industry average, it suggests that investors believe that the company has more significant future growth opportunities than its industry peers.

It may not be appropriate to compare price to book ratios of companies in different industries because the ratio also reflects investors' growth outlook for the industry itself.


Accounting Return on Equity

An important measure used by investors to evaluate the effectiveness of management in increasing the company's book value is accounting return on equity.

QUICKIES: Seven investment myths you should not fall for

Text: Prerna Katiyar | ET Bureau

Pick this stock, it's trading at 52-week low.' 'That stock is a multi-bagger, trading at such a low PE.' 'Penny stocks make fortunes while stocks trading below book value are a sure pick for making quick bucks.'

Haven't we all heard such statements at some point in our lives? If you are one of those who believe in such assertions, read on. For, these are among the many myths in investing.



Here we list seven of them


Myth No 1: Stocks trading below book value are cheap

Book value (BV) is the actual worth of a stock as in a company's books/balance sheet, or the cost of an asset minus accumulated depreciation.

BV depends more on historical cost and depreciation and often has little correlation to the current share price.

Shares of industries that are capital intensive trade at lower price/ book ratios, as they generate lower earnings. On the other hand, those business models that have more human capital will fetch higher earnings and will trade at higher price/book ratios.

"Price/book (ratio) of below 1 may be cheap but one should see other aspects such as earnings forecast, guidance, management and debt on the books of the company ," says Angel Broking's equity derivatives head Siddarth Bhamre.


Myth No 2: Stocks trading at low P/E are under-valued

Price to earning ratio (P/E) is one of the most talked about ratios in the market. This is based on the theory that stocks with low P/Es are cheap.

However, P/E alone doesn't tell much about the stock price. P/E multiples may be a quick way to value a stock but one should look at this in correlation with expected growth earnings, the risk factors involved, company's performance and growth potential .

"This is surely a myth. It is also an indication of uncertain future earning of the stock concerned," says Birla Sunlife Mutual Fund CEO A Balasubramanian.

The idea behind dividing price with earnings is to create a levelplaying field where some kind of comparison can be made between high- and low-priced stocks.

Since P/E ratios vary across sectors, with growth stocks consistently trading at higher P/E, one can only compare the P/E ratio of a stock to the average P/E ratio of stocks in that sector.


Myth No. 3: Penny stocks make good fortunes

Penny stocks by nature are lowpriced , speculative and risky because of their limited liquidity, following and disclosure.

If it's easy to invest in penny stocks - as here you shell out much less money per share than you would require for a blue-chip firm - it's also easy to lose.

Says Bhamre, "Fortune can be made by high-denomination stocks also. Denomination has nothing to do with the rationale for picking a stock. Generally , retail investors are fond of stocks that are at sub- Rs 100 levels. But there may be stocks that may be trading in Rs 1,000-plus price but may well be cheap. Clarity on earnings is more important here. Anytime, I would be more comfortable buying an ICICI Bank (currently trading at Rs 1,038) than an IFCI at Rs 45. One should look at earnings visibility."


Myth No. 4: The worst is over in the stock market

Timing the market, a common strategy among investors, means forecasting and that should best be left to astrologers and tarot readers.

If one has done one's valuation studies, one shouldn't worry about timing the market. No one had predicted the bull run would take the Sensex from a level of 10,000 in February 2006 to over 21,000 in January 2008 - just as no one had any idea of the following crash, which saw the same index plummeting to 9,000 in March 2009.

"Timing the market is more of a gut feeling. It's more on the basis of perception, as there is no such thing (that the worst is over) when the future is uncertain. One can never surely time the market. The worst is over is more of a probability than a certainty. Timing the market is very difficult as market is driven not just by earnings but also by sentiments ," says Balasubramanian.


Myth No 5: Stocks that give high dividends are the best bet

This comes from the notion that regular dividends are extra income in the shareholder's hand. This may not always be true.

While a company may be making decent payouts every year, the share price appreciation may not be comparatively high. Before investing in companies paying high dividends, it's important to analyse if the company is reinvesting enough profit to grow its earnings consistently.

Says Brics Securities' research VP Sonam Udasi: "It's not dividend that matters but the yield. For eg, a company may pay a 100% or even a 300% dividend on a stock with face value of Rs 10.

So, the investor may receive Rs 10 or Rs 30 per share when the stock may be currently trading at Rs 800 or Rs 1000. This would translate into an yield of 1% or 3% only. Also, such companies may not necessarily be reinvesting their earnings in the business to generate future earnings and so there may be no stock movement. The dividend may be high but the EPS and growth per se may be constant."



Myth N0 6: Index stocks are the best stocks

If this was true, most investors would safely park their money in such stocks in anticipation of maximum profit without looking out for other value stocks.

Most indices are a collection of stocks with the highest market cap. Take, for eg, the Sensex.

Companies that make up the index are some of the largest, with stocks that are highly traded based on their free-float.

"Index stocks may not necessarily be the best stocks as they are mostly based on market-cap or free-float of the company and not earnings. This doesn't mean that all stocks of the Sensex are highearning stocks. One must take a stock-by-stock call," says Balasubramanian of Birla Sun Life Mutual Fund.

The stock price of a company depends on its earnings. One can find high-earning stocks outside the key indices as well, he says. The risk is certainly less with index stocks as they are well researched and leaders in their respective sectors, but, again, the margins may not be very high. So it's better to keep your eyes open to other stocks, too.



Myth No 7: Stocks trading at 52-week low are cheap

Says Udasi: "There may be a time in the economic cycle when a blue-chip stock may hit a 52-week low.

But the first thing that should come to one's mind is why did the stock hit the 52-week low.

There must be something fundamentally wrong with the stock if it has hit a 52-week low, and chances are they may hit a new 52-week low.

52-week low in itself guarantees nothing. If at all one is picking stocks at 52-week lows, they should have a long-term horizon so that when the economic cycle turns, the stock is able to recover."

Needless to say, quality matters most while buying any stock.


http://economictimes.indiatimes.com/seven-investment-myths-you-should-not-fall-for/quickiearticleshow/9438662.cms

Measurement in the Balance Sheet

Book values measurement determines the price-to-book ratio. To evaluate the price-to-book ratio, we must understand how book values are measured.

The values of some assets and liabilities are easy to measure, and the accountant does so. He applies mark-to-market accounting, thus recording these items on the balance sheets at fair value (in accounting terms). These items do not contribute to the premium over book value.

But for many items, the accountant does not, or cannot, mark to market. He applies historical cost accounting. U.S. GAAP gives measurement rules for items commonly found on balance sheets, with those carried at fair value and historical cost indicated. International accounting standards broadly follow similar rules.

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Example:

Company A Balance Sheet

Cash and cash equivalent $7.764 million
Short term investments $208 million
Long term investments (mainly interest bearing debt securities) $1,560 million.

Comment:  A market value is usually available for these securities, so they can be marked to market.

Accounts payable $11,492 million
Long term debt $362 million

Comment:  The accounts payable is close to market value and, while the long-term debt is not marked to market, its book value approximates market value unless interest rates change significantly.

So all these items above do not contribute to price premium over book value.

Net accounts receivable $5,961 million
Financing receivables $1,732 million
Accrued expenses $4,323 million
Other "liabilities" $2,070 million

Comment:  All the above 4 items involve estimates, but if these are made in an unbiased way, these items, too, are at fair value.

Company A
2,060 outstanding shares
Market Price $20 per share.
Market value of these shares: $41,200 million.
Book value $3,735 million
Therefore the market premium was $37,465 million.

Comments:
The market saw $37,465 million of shareholder value that was not on the balance sheet.
And it saw $37,465 million of net assets that were not on the balance sheet.
With 2060 million shares outstanding,

• the book value per share (BPS) was $1.81 and
• the market premium was $18.19 per share.

How does one account for Company A's large market premium of $37,465 million over the book value of its equity?

The large market premium of $37,465 million over the book value of its equity arises largely from

• tangible assets, recorded at (depreciated) historical cost, and
• unrecorded assets.

The latter are likely to be quite significant. Company A's value, it is claimed, comes not so much from tangible assets, but from

• its innovative "direct-to-customer" process,
• its supply chain, and
• its brand name.

None of these assets are on its balance sheet.

• Nor might we want them to be.
• Identifying them and measuring their value is a very difficult task, and we would probably end up with very doubtful, speculative numbers.

The Market Price-to-Book and Intrinsic Price-to-Book Ratio

The balance sheet equation corresponds to the value equation. 

 

The value equation can be written as:

 

Value of the firm = Value of equity + Value of debt
or
Value of equity = Value of firm - Value of debt

 

• The value of the firm is the value of the firm's assets and its investments.
•  The value of the debt is the value of the liability claims.

 

The value equation and the balance sheet equation are of the same form but differ in how the assets, liabilities, and equity are measured.

 

The measure of stockholders' equity on the balance sheet,l the book value of equity, typically does not give the intrinsic value of what the equity is worth. 

• Correspondingly, the net assets are not measured at their values. 
• If they were, there would be no analysis to do!  It is because the accountant does not, or cannot, calculate the intrinsic value that fundamental analysis is required.

The diffeence between the intrinsic value of equity and its book value is called the intrinsic premium:

 

Intrinsic premium = Intrinsic value of equity - Book value of equity

 

The difference between the market price of equity and its book value is called the market premium:

 

Market premium = Market price of equity - Book value of equity

 

If these premiums are negative, they are called discounts (from book value).  Premiums sometimes are referred to as unrecorded goodwill because someone purchasing the firm at a price greater than book value could record the premium paid as an asset, purchased goodwill, on the balance sheet; without a purchase of the firm, the premium is unrecorded.

 

Premiums can be calculated for the total equity or on a per-share basis.

 

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Example:
Company A
2,060 outstanding shares
Market Price $20 per share.
Market value of these shares: $41,200 million.
Book value $3,735 million
Therefore the market premium was $37,465 million.

 

Comments: 
The market saw $37,465 million of shareholder value that was not on the balance sheet.
And it saw $37,465 million of net assets that were not on the balance sheet.
With 2060 million shares outstanding,

• the book value per share (BPS) was $1.81 and
• the market premium was $18.19 per share.

-----

 

 

The ratio of market price to book value is the price-to-book ratio or the market-to-book ratio.

 

The ratio of intrinsic value to book value is the intrinsic price-to-book ratio. 

 

• Investors talk of buying a firm for a number of times book value, referring to the P/B ratio. 
• The market P/B ratio is the multiple of book value at the current market price. 
• The intrinsic P/B ratio is the multiple of book value that the equation is worth. 
• An investor will spend considerable time estimating intrinsic price-to-book ratios and asking if those intrinsic ratios indicate the the market P/B is mispriced.

Historical Perspective of P/B ratios

 

In asking such questions, it is important to have a sense of history so that any calculation can be judged against what was normal in the past.  The history provides a benchmark for our analysis.  

• P/B ratios in the 1990s were high relative to historical averages, indicating that the stock market was overvalued.  
• The medican P/B ratios (the 50th percentile) for the U.S. listed firms were indeed high in the 1990s - over 2.0 - relative to the 1970s. 
• But they were around 2.0 in the 1960s. 
• The 1970s experienced exceptionally low P/B ratios, with medians below 1.0 in some years.

 

What causes the variation in ratios? 

• Is it due to mispricing in the stock market?
• Is it due to the way accountants calculate book values?

 

The low P/B ratios in the 1970s certainly preceded a long bull market.

• Could this bull market have been forecast in 1974 by an analysis of intrinsic P/B ratios?
• Were market P/B ratios in 1974 too low? 
• Would an analysis of intrinsic P/B ratios in the 1990s find that they were too high?

 

Company A's P/B of 11.0 in 2008 looks high relative to historical averages.

• Was it too high?

 

The fundamental investor sees himself as providing answers to these questions.  He estimates the intrinsic value of equity that is not recorded on the balance sheet. 

 

You can screen for firms with particular levels of P/B ratios using stock screener from links on the Web.