The book-to-market ratio compares a company’s true value with its market value, with a ratio greater than one indicating undervaluation and less than one indicating overvaluation. Earnings announcements can cause the ratio to adjust, but rogue accounting can create artificially high ratios that lead to stock price drops.
A book-to-market ratio is a mathematical comparison of a company’s true value with its market value. The real value of a company is determined by internal accounting, and its market value is its market capitalization. In general, 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, often resulting in public upgrades or downgrades of those shares.
The calculation of a book-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 make every three months. In general, the market value is equal to the market capitalization of the company, which can be calculated by multiplying the price of its shares by the total number of shares 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 getting a ratio greater than one requires book value to exceed market value, which may indicate investors haven’t given the company the credit it deserves. Similarly, a book-to-market ratio of 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 on their shares. The reasoning here is that for the ratio to be less than one, the company’s market value must have exceeded its book value, meaning that the investing public may have given the company too much credit.
Earnings announcements can create opportunities for investors because they cause book-to-market ratios to adjust. When a company announces its earnings, those earnings are added to its previous book value, causing the book-to-market ratio to increase. Typically, investors will take a rising ratio to indicate that a company is doing well and may be worth investing in. This additional investment increases the market value of the company and brings the relationship closer to value once again.
A historical problem with using the book-market ratio as an investment guide is that certain companies are known for crooked accounting. Rogue accounting cases create artificially high book-to-market ratios that attract investors. When the actual 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.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
