As you've likely heard me say previously, the way to create wealth in the stock market is by buying good and great companies at good and great prices. It is virtually impossible for even the greatest of investors to always get good and great companies at the lowest prices - and the simple fact is that great investors like Warren Buffett know this, and are hence willing to pick up good and great companies at good prices than let the opportunity pass them by.
So today, I want to add a small yet powerful new weapon to your investing arsenal by sharing the concept of Book Value of a stock. Simply put, the Book Value of a stock is the net value left for shareholders after a company pays off all its liabilities such as its employees' salaries, accrued vacation time, suppliers' dues for raw material, taxes owed to the government, money borrowed from banks or other lenders, and so on... Once all its liabilities are paid, what is left free and clear for shareholders is called the company's Book Value. Now when you divide this $ Book Value by the total number of shares outstanding, you get the Book Value Per Share, which is a useful number to know because most investors focus on Per Share prices as they invest.
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To give you a simple example, if a company has a Book Value of say $150 million and has 10 million shares outstanding, its Book Value per share is $150 million divided by 10 million, which is $15. Of course, I am overly simplifying things here... but just so you can easily understand the concept of Book Value.
Book Value is also known as Shareholders' Equity and can typically be found at the bottom of a company's balance sheet, and can often be found on online brokerage screens.
Now here's why Book Value Per Share is important. Let's say the Book Value per Share is $15 and the stock is actually trading at $20. Then you know that the stock is trading at a 33% premium over its Book Value, perhaps for good reason or not. But if the stock is trading at $10, then it's at a 33% discount over its Book Value and may just be attractive and worth investigating, simply because you could end up getting something at a price that is significantly less than its actual value, which could leave you with significant upside and possibly good returns.
Now, you probably also noticed that I am being a little circumspect here - and you're right. Because a discount to Book Value does not always guarantee a winner - there may be other factors that you're not aware of, such as an impending lawsuit or a large unsettled claim against a company that might come due (think BP after the Florida oil spill disaster), or significant competition that could cause its market share to drop and hurt revenue and profits, that may yet not be factored into the updated Book Value - simply because Book Values are typically put out once every quarter with financial result announcements. So while l certainly think there are great bargains to be found by comparing the Book Value to the price per share, I also want you to exercise restraint and caution and understand the pitfalls, and therefore do more research before you buy the stock.
While there is extensive research - from Nobel laureates Eugene Fama and Kenneth French, no less - that shows that stocks where the Book Value is less than the share price continually beat the market, you must be particularly careful with this metric when you invest in one stock at a time.
Having said all this, knowing book value or as I said before, shareholder's equity, is one of the most important numbers you should be able to identify. Now if you take the earnings per share and divide it into the book value-stay with me here---you can calculate a company's rate of return on shareholder's money. That's the rate of return on YOUR money. It's called ROE or "Return on Equity"-and this important metric will tell you how the company is handling your money. A low ROE means they are NOT doing a great job. A high return on equity is what you want to see.
And finally, companies with consistently high rates of return on your shareholder money may prove that the company is almost immune from competition---and may be able to grow its earnings for many years to come.
And this, above all else, is the best thing an investor can hope for.
Steve Pomeranz is a Managing Director for United Capital Financial Advisers, LLC, "United Capital", and owner of On The Money. On The Money is not affiliated with United Capital.
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