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How should I use book value when evaluating a stock?

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The topic of this article is how you should use book value when evaluating a stock. Let's start out with a few basic definitions of book value. Basically, the book value of a stock is your equity of a business, as a shareholder. The equity is valued in assets and liabilities, and is determined by the accounting books. This is why it is called the book value. The book value of a stock is the way that accounting measures determine the historical cost of the stock, as opposed to the immediate, current market price of a stock.

Another way to define book value is to say that the book value is the amount that a company is worth if it is liquefied today, after all of its debts are paid off. The book value is the common stock equity of a company as you would see it on a balance sheet. The book value is determined by taking the total assets of a company, and then subtracting any liabilities, any preferred stock, and any intangible assets like goodwill, if there are any. The majority of the time, the book value is actually less than the market capitalization of a particular company because companies are expected, generally, to grow in profit and become more profitable in the future. The book value is an especially important measurement of stocks and of companies if you are a value investor.

Value investment is a particular way to select stocks and approach investment, as opposed and compared to growth investment. Value investors generally invest in companies that seem to have fallen behind and been left by the stock market, but still show the potential for long term improvement and growth. If you are a value investor, you are looking for stocks that are not traded and priced correctly by the market, for various reasons. The stocks that you buy and the companies that you invest in are actually of greater value than is reflected in their price.

The only way that you can know if a business is worth more than the market says it is if you are deeply interested in the industry itself and take a lot of time to investigate a particular company. You examine things like earnings growth, cash flow, dividends, and book value, instead of the pure, immediate market value. You also hold stocks with a company for a long time until the market realizes the value of the company and raises the prices. Now, this doesn't just mean that you invest in stocks that have dropped in price, since for the majority of those, the stocks drop for a reason: the company just isn't worth much. Its revenues and earnings are going down, it has poor management, it experiences a serious crisis and scandal with one of its major products (pharmaceuticals, anyone?), something like that. Value investors buy stocks in companies that actually are doing well, but are incorrectly priced.

If you are interested in value investment, then you are going to look at the P/E ratio (which should be in the bottom 10% of the sector), a PEG ratio that is less than 1, a Debt to Equity ratio that is lower than 1, but still strong earnings growth over a long period of time. You will also look at a price to book ratio of one or less. And this is where you need to know the book ratio when you are evaluating a stock. The price to book ratio, or P/B ratio, is a measurement that displays the value that the market places on the company versus what it is worth according to the accounting books, which take in account assets and liability. So if the amount of the ratio is less than one, the better the value of the stock, since that means that the actual book value is more than the amount that the market says a company is worth. In this way, the P/B ratio is like the P/E ratio, in telling you which stocks will be a wise investment and will, with a little patience, end up yielding you some pretty nice returns in the future.

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