Equity Valuation: Book Value, Liquidation Value, and the Q Ratio

One measure to determine whether a stock is a good investment is whether the company is worth at least the value of all of the outstanding stock at current market prices. Most measures of company worth are based on the net value of its assets, = total assets – total liabilities. Of course, most companies are worth more than the sum of their net assets. For instance, when a company buys another company, then it records part of the worth of that company as goodwill, equal to the perceived value of the company, usually measured by its market price if it is available, over its net assets. But goodwill cannot really be measured: market prices may not accurately represent the viability of a business, or the business may not even have a market price if it is not on the market. Hence, whether the valuation of goodwill is accurate will not be known until later. This is why generally accepted accounting procedures require that goodwill be written down if the value of the business turns out to be less than what was estimated. Although net assets will not necessarily show the true value of a company, it will generally show its minimum worth — and it can be measured accurately. The 3 most common methods of measuring company worth in terms of its net assets are book value, liquidation value, and the Q ratio. Book value is the net worth of the company's assets based on historical prices; liquidation value uses market prices, while the Q ratio, otherwise known as Tobin's Q, uses replacement costs.

Book Value

Companies whose stock sells for less than book value is generally considered undervalued, or having less risk than companies selling for greater than book value. Because most companies sell for much more than book value, a company selling for less than book value may well have considerable upside potential. In fact, 1 of the 10 rules listed by Benjamin Graham in his classic book on value investing, Security Analysis, states that the stock price should be less then 2/3 of the firm's book value minus any values for goodwill or other intangible assets. The value of intangible assets is subtracted because their value is often inflated, in which case, they will eventually have to be written down. Often, however, a company sells for less than book value because it is financially troubled, or because the market thinks the company's prospects are bleak.

The book value of a company's stock is simply the stockholders' equity per common share of stock, equal to the net asset value, equal to total assets minus intangible assets, such as goodwill, minus total liabilities minus equity related prior claims, including preferred stock and cumulative dividends in arrears, divided by the number of outstanding common shares. Treasury stock, which is the repurchase of outstanding stock by the company, is not include in outstanding shares.

Net Asset Value for Common Stock = Total Assets - Intangible Assets - Total Liabilities - Equity with Prior Claims = Stockholders' Equity

Book Value per Common Share Formula
Book Value per Common Share =Net Asset Value
Number of Outstanding Common Shares
Treasury stock
is not included.

Book value can also be calculated for bonds and preferred stock. Because bonds are senior to preferred stock, which are senior to common stock, their corresponding net asset values are greater, and, consequently, their corresponding book values are greater.

Bond Book Value > Preferred Stock Book Value > Common Stock Book Value

If the company has preferred stock, then the greater of call price or par value of the stock times the number of preferred shares must be subtracted from company assets to determine stockholders' equity, since, in a liquidation, preferred shareholders must be paid these amounts before common stockholders receive anything.

Example — Calculating Book Value for a Company with Preferred Stock

If

Then

Any cumulative dividends in arrears must also be subtracted, since these dividends must be paid before common stockholders can receive anything in a bankruptcy or a liquidation.

Example — Calculating Book Value for a Company with Preferred Stock and Cumulative Dividends in Arrears

If, using the above example

Then

Liquidation Value

The liquidation value of a company is equal to what remains after all assets have been sold and all liabilities have been paid. It differs from book value in that assets would be sold at market prices, whereas book value uses the historical costs of assets. This is considered a better floor price than book value for a company, because if a company drops significantly below this price, then someone, such as a corporate raider, can buy enough stock to take control of it, and then liquidate it for a riskless profit. Of course, the company's stock price would have to be low enough to cover the costs of liquidation and the uncertainty of actual selling prices of the assets in the marketplace.

Q Ratio, or Tobin's Q

Another theory related to book value is that a firm cannot sell for much less or much more than the replacement cost of its assets minus its liabilities, which is quantified by the Q ratio, also known as Tobin's Q, because it was developed by James Tobin, who hypothesized that the total market value of all companies must be relatively equal to the replacement value of their assets minus their liabilities.

For an individual company, the Q ratio is equal to the market price of the firm divided by its replacement cost.

Tobin's Q Ratio Formula
Q Ratio =Market Price of Firm
Replacement Cost

If the Q ratio is significantly less than 1, then it would be cheaper for potential competitors to buy the firm rather than start a new business, so this would tend to increase its market price. If it sold for significantly more than the Q ratio of 1, then competitors would enter the market, and drive down the price of the firm until it was approximately equal to 1.

Because the replacement cost of a company would be difficult to ascertain quickly, the Q ratio cannot be a driving force in determining daily stock prices for companies. However, it could be an indicator for long-term trends and as a potential takeover target if the company's Q ratio is less than 1.

If individuals or companies want to enter a business, certainly it would be an important consideration whether they could buy a business for less than what it would take to replicate the company by starting from scratch, especially since an established company would already have customers.

Conclusion

Book value will have a greater impact on daily stock prices, since the book values of all public companies are widely available as a key statistic—not so for liquidation values or for Q ratios. Liquidation values and Q ratios can, however, serve as indicators for potential long-term trends.