Balance Sheet Analysis. Significance of Book Value

 Practical Significance of Book Value: Book value of a common stock was originally the most important element in its financial exhibit. This idea has almost completely disappeared and book value has lost practically all its significance. This change arose because first, the value of the fixed assets, as stated, frequently bore no relationship to the actual cost and second, that in an even larger proportion of the cases these values bore no relationship to the figure at which they would be sold or the figure which would be justified by the earnings.

· In any particular case the message that the book value conveys may well prove to be inconsequential and unworthy of attention. But this testimony should be examined before it is rejected. Let the stock buyer, if he lays any claim to intelligence, at least be able to tell himself, first, what value he is actually setting on the business and, second, what he is actually getting for his money in terms of tangible resources.

· A business that sells at a premium to asset value does so because it earns a large return upon its capital; this large premium attracts competition, and, generally speaking, it is not likely to continue indefinitely. Conversely, in the case of a business selling at a large discount because of abnormally low earnings. The absence of new competition, the withdrawal of old competition from the field and other economic forces may tend eventually to improve the situation and restore a normal rate of profit on investment.

· Although this is orthodox economic theory, and undoubtedly valid in a broad sense, we doubt if it applies with sufficient certainty and celerity to make it useful as a governing factor in common stock selection. Under modern conditions the so called ―intangibles‖are every whit as real from a dollars and cents standpoint as are buildings and machinery. Earnings based on these intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities. Furthermore, when conditions are favorable the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth. Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales.

Therefore, it is not possible to lay down any rules on the subject of book value in relation to market price, except the strong recommendation already made that the purchaser know what he is doing on this score and be satisfied in his own mind that he is acting sensibly.