Book value can show some great bargains but please be careful

The book value of a company is the total assets on the balance sheet minus the liabilities. This is the net worth of the company. It’s what shareholders actually own. If the company suddenly closed its doors tomorrow and paid off the debt, this is the amount of money that would be left to pay you and your fellow shareholders.

Some investors will look at the book value compared to the stock price. If the stock price is higher than the book value, it could be overpriced. However, realize that stock prices may factor in what some investors believe are the future earnings and performance of the company. The stock price is also subject to the herd mentality of owning a stock. Book value simply looks at current assets.

A stock trading less than its book value doesn’t necessarily mean it is a bargain. Book value does consider future earnings or the expectation of great performance.

I almost never talk about the book value of a company when I do my stock analysis on this site. I find it to be a metric that makes little sense when taken over the course of time. To me, it is more important to see if a company consistently performs well; as that is a great indicator that it will continue to perform. Just as when you hire a new employee for your firm, you hire that person because you feel s/he has performed well in the past and you expect that performance to continue into the future.

Book value tends to be important for a single point in time and not a trend that continuously gets better or worse. So if you believe in the notion of consistent performance in the past means that future performance is likely, then the book value has diminished importance. As I have tweeted many times under @ConfidentInvest, past performance may not be a perfect tool for predicting the future, but it is the best tool that we have at our disposal.

This is why book value rarely matters; the value of future performance is typically a far bigger driver of a stock price. Share prices of companies regularly exceed book value when investors believe that there is some confidence of future performance.

There are times when book value can be a signal for a good bargain. During the financial crisis of the 2007 and 2008, Goldman Sachs [stckqut]GS[/stckqut] had a book value in the mid $80 range. At its low in that time frame, it was trading at about $50. This was due to concern about its ability to have future earnings as a company. The herd mentality of the company drove the stock price down. If you bought at that price, you could have made a nice profit. This profit would have been realized even though Goldman may not have been a Good Company at that time.

Book value is where you may want to veer from the analysis on my site. There are times that you will find a company that is simply been beaten down too far. If you see that this downtrodden company is trading below its book value, you may want to consider an investment. Please be careful with this investment though since worse times often follow bad times. Not all companies that are trading under book value will ever recover from their illnesses.

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