Using This Measure Could Kill Your Portfolio Returns
A question that gets much attention among investors is how, exactly, to find the fair value of a company. The reason behind why this question is the focus of so much attention is very simple: once an investor finds the fair value of a company, they can make investment decisions accordingly. For example, if an investor finds the fair value of a company to be $1.00, and if the market price of the stock is $0.50, they may consider it to be undervalued and buy stocks in hopes of making a decent rate of return.
To find the fair value of a company, investors may look at many measures, but often, investors may predict the fair value of the company by just looking at its book value per share.
At the very core, the book value per share of a company is simply the difference between its assets (what the company has) and its liabilities (what the company owes) divided by the number of outstanding shares. This value provides investors with an idea about the price per share if the company stops doing business immediately.
For example, if a company has assets of $1.0 million and liabilities of $500,000 with outstanding shares of 100,000, then the book value per share of the company will be $5.00 per share.
Keeping all of this in mind, does this value actually tell an investor anything about the company’s future growth? The sad reality is that no, it doesn’t.
First and foremost, investors should know that the book value per share of a company is just a static calculation based on past results. Companies only report changes in their assets and liabilities on a quarterly basis; therefore, the picture of the value investors may see may not be true. What if the company adds more debt over a quarter and reduces its assets?
Another problem with just looking at book value per share is that it doesn’t really say much about the company’s sales growth and profitability—factors that drive the stock price higher.
Consider the Penn Virginia Corporation (NYSE/PVA), an independent oil and gas company, for example. The company’s book value per share is $16.28 per share, but the stock is currently trading close to $4.25. (Source: Yahoo! Finance web site, last accessed April 25, 2013.) Does it suggest that the company is undervalued?
The company has continuously been posting losses. Penn Virginia registered a loss of $2.22 per diluted share in 2012, losses amounting to $2.90 per diluted share in 2011, and losses of $0.19 per diluted share in 2010. (Source: “Penn Virginia Corporation and Subsidiaries Annual Report on Form 10-K,” Penn Virginia web site, last accessed April 25, 2013.)
Making a decision to buy a certain stock just by looking at the book value per share can result in severe losses in an investor’s portfolio, since it doesn’t really provide a forward-looking picture of the company’s performance.
This by no means suggests that investors shouldn’t use a company’s book value per share to find its fair value. But in order to make better investment decisions, investors should look at different measures of finding the fair value of a company, as well. By doing this, investors can get a better idea about the company and increase their chances of profitability.