A value investor is considering investing in shares of Microscam International, believing that the market price of Microscam is less than the "intrinsic value" of the shares. In his research, this value investor has gathered the following information about Microscam International:
Total assets: $200,000,000 -
Total liabilities: $130,000,000 -
Number of common shares outstanding: 3,000,000
Current stock price: $22.15 per share
Required return: 18.75% per year
Expected growth rate: 17% per year
Next dividend: $0.30 per share -
Earnings per share: $3.88 -
Using this information, what is the book value of Microscam International? Further, are the beliefs of this value investor justified? Assume that the book value calculation accurately illustrates the liquidation value of Microscam.
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A. B. C. D. E. F.Explanation
The book value of a common stock is found by dividing the net worth of a company by the number of outstanding shares. While there exists several different methods for calculating net worth, the most simplistic involves subtracting total liabilities from total assets, giving us the shareholder's equity figure.
Investment professionals often see the book value as a "floor" for common stock prices, and the price-to-book ratio is quite popular in the field of investment management. The calculation of the price-to-book ratio involves the following equation:
Price-to-book ratio = {Market price of common stock at t0 / [(total assets - total liabilities) / # of common shares outstanding]}
While the # of common shares outstanding has been provided, the shareholder's equity figure must be calculated manually. The calculation of the per share shareholders equity is illustrated as follows:
Shareholders equity = [($200,000,000 - $130,000,000) / 3,000,000] = $23.33.
Now that the shareholders equity has been calculated and transformed into a per-share figure, the priceto-book value can be calculated as follows:
Price-to-book value = ($22.15 / $23.33) = 0.94942.
As you can see, the required rate of return, along with the expected growth rate, is not necessary in the calculation of the price-to-book ratio.
Any time the price-to-book ratio is less than one, a stock is said to be "trading at a discount to book."
Frequently, investment professionals will use the term "intrinsic value" when referring to the book value, and thus stocks trading below their book value are often referred to as being priced "below their intrinsic value." Stocks trading below book value are often sought after by value investors, who believe that these shares have been discounted below their real value.
A figure of more than one for the price-to-book ratio is commonly referred to as "trading at a premium to book."
While the price-to-book value is a useful tool in the stock selection process, it possesses some important flaws. One problem with the Price-To-Book Ratio is that one of the terms - Book Value - is so easily manipulated. Valuation of inventory and real estate are easily adjusted on the books. Stock buy-backs and write-offs of exceptional items also deflate Book Value, making high priced stocks seem overvalued.