Book value per share is one alternative to assess whether the market price for a stock is overvalued or undervalued. Although it contains weaknesses. Calculating it is also easy, you only need to use arithmetic calculations. For the data, you can find it in the shareholders’ equity in the balance sheet.
What is the book value per share?
Book value per share is the ratio of shareholders’ equity to the average ordinary shares (common stock) outstanding. That is the amount that ordinary shareholders will receive when the company is liquidated.
For example, suppose you have 1,000 shares of a company, and the book value per share is Rp5. After paying all the liabilities, you will get a share of Rp5,000 (1,000 x Rp5).
You might use this metric to compare the market price of a company’s current shares, whether overvalued or undervalued. But remember, this metric is only based on accounting estimates, not based on market-based calculations.
How to calculate book value per share
The calculation is easy. You just divide the book value of shareholders’ equity by the average outstanding ordinary shares outstanding. You can find the numbers in the owner’s equity of the balance sheet. Here is the formula:
Book value per share = (Total equity – Preferred shares) / Average of outstanding ordinary shares
From the equation above, this metric only measures the value of ordinary shares. So, you have to deduct the total shareholder equity with preferred shares.
For example, a company reports total shareholder equity of IDR100,000 in 2019, of which around IDR10,000 is preferred stock. Meanwhile, the average outstanding ordinary share was 50,000 shares.
From the information, we can calculate the book value per share as :
Book value per share = (IDR100,000 – IDR10,000) / 50,000 = IDR 1.8 per share
Why use average shares outstanding? Total outstanding shares may change due to share buybacks or the issuance of new shares. It can deflect the results you get. So, for that reason, you should use the average number.
Why book value per share is important
Investors might use this metric as supplementary information in analyzing the company’s stock price. It is a relative valuation to compare the market price per share of a company. If the value is lower than the market price per share, the stock is overvalued. Conversely, if the value is higher than the market price of the company’s shares, it is undervalued.
Say, on a stock exchange, the price of a company’s stock in the example above is IDR3 per share. Since the book value per share is IDR1,8, the stock is overvalued, and the share price will likely go down.
How to increase book value per share
Two ways to increase book value per share:
- Increase the total shareholder equity – the numerator value is higher
- Reduce the number of shares outstanding – the denominator is lower
To increase shareholder equity, the company should post positive growth of retained earnings. And, retained earnings increase if the company’s net profit increases or dividend payments decrease. To understand this, you can derive the formula from shareholder equity (assuming other factors are constant), which is:
Shareholder equity = Initial retained earnings + Net income – Dividends
The next, shareholder equity also increases if the company uses the profit to reduce liabilities or buy more assets.
And, the final, the repurchase of common shares will also increase the book value per share. Buybacks reduce outstanding shares, causing the denominator to be lower.
For above case, if a company buys 10,000 shares, the outstanding shares decrease to 40,000. That will result a book value per share: (IDR 100,000 – IDR 10,000) / 40,000 = IDR 2.25 per share.
Why book value per share provides an inaccurate picture of the company’s stock price going forward
The weakness of this metric is that its value is based on accounting calculations. It provides foresight, so it is a less accurate measure to predict the company’s stock price.
Book value does not reflect factors such as investors’ perception. In fact, such factors can affect market prices for company shares. The book value also does not provide complete information about the company’s free cash flow, a key indicator in valuation using the discounted cash flow method.