Before investing in a corporation, it’s a good idea to determine the overall value of that company. This can often be a tough thing to do, because ultimately, a company is really worth what someone will pay for it. Hard figures, though, are often needed when determining whether a company will be a good investment or not.
There are several ways to determine the value of an organization. For the forward looking person, value can be determined based on one’s expectations of future profits. This is called the Rule of Thumb method, and it generates the value of the company by multiplying the earnings before interest and taxes by a multiplier, which is usually 3, 4, or 5. This multiplier is based on the amount of assets, and represents the number of years that the purchaser would need to earn back the investment. Thus, a company without many assets would generate a 3 multiplier, and one with a lot of assets might need a 5.
The book value of the corporation is another way to determine the overall worth. This method is used when determining whether the shares of a company are a good buy at a certain level. To determine the book value of a company, one must calculate the total value of all of its assets, and then subtract the value of its intangible assets, such as goodwill and patents. Then, the value of all of its liabilities is also subtracted from the result. The figure generated is also known as the net asset value of the company.
This number is one tool that an investor can use to see if a company’s shares are expensive or not. By dividing the corporation’s book value by the total number of outstanding shares, one can determine the book value per share. This can then be used to generate a ratio of price-to-book-value, or P/B. For example, if there are 2 million shares outstanding for XYZ Company, and the book value of the company is 10 million dollars, then the book value per share is 5. Now say the price of a share of XYZ stock is $15. The price-to-book-value of the company would then be 3. This number by itself doesn’t tell a whole lot, but when compared with the P/B ratio of many other companies in the same industry, an investor can determine which stocks are cheap compared to the amount of assets the company owns. This can in turn point out companies that might be currently ignored by the market, and as a result have a relatively cheap share price.
Of course, there could be many other factors involved in the low stock price, such as pending legal action or bad management, so obviously due diligence is warranted. But by determining the book value of a company, and then the resulting ratios, an investor has yet another tool in his arsenal to be able to make great investment decisions by choosing stocks wisely.