Book-to-Market Ratio

Book-to-Market Ratio
See also
Market value added Free cash flow yield Market value ratios Market Risk Premium Bird-in-the-hand theory Book value per share Growth shares Altman Z score Appraisal right

The book-to-market ratio is the book worth of equity apportioned by the market worth of equity. The emphasized book-to-market result is also named as value impact. In crude terms, great book-to-market shares also mentioned as value stocks, gain important positive excess revenues while low book-to-market stocks, also referred as growth shares, obtain meaningful negative excess returns. The effect of this ratio is adequately recorded in economics (N.Cakici, K.Topyan 2014, chap.9). The book-to-market ratio ventures to recognize undervalued or overvalued securities. The book-to-market proportion and the measurement of a company's investment are set determinants that have been affirmed to be beneficial in defining the cross-sectional difference in consequent returns (A.R. DeFusco, W.D. McLeavey, E.J. Pinto, E.D. Runkle, J.P.M. Anson 2015, p.449).

Formula of the Book-to-Market Ratio

The formula of the Book-to-Market Ratio is presented as (J.Y.Campbell., A.W.Lo., A.C.MacKinlay 2012, p.240):

$Book-to-Market\,Ratio={\frac {Book\,value\,of\,equity}{Market\,value\,of\,equity}}$

Assumptions of the Book-to-Market Ratio

Assumptions of the Book-to-Market Ratio are presented qua (W.H.Beaver, M.Correia, M.McNichols 2011, p.54-55):

• If the accounting book amount of investment and market worth of equity are equal, the proportion would be 1, or there are unrecognized improvements in the financial value of material values or unrecognized intangible assets, in which case the ratio is below 1.
• The Book-to-Market ratio could take values from one if economic attenuation to asset amounts are unrecognized in which case the rate is over 1.
• If book to market ratios have the biggest departure from 1, the prophetic power of the bankruptcy models, both valuing and market-based is smaller.

An inverse of the Book-to-Market Ratio

The market-to-book ratio is inverse of the book-to-market ratio. Similar to the book-to-market ratio, it aims to estimate whether the company's stocks are exaggerated or undervalued by confronting the market price of all outstanding shares with the company's equity. The formula of the Market-to-book ratio is presented as (E.F.Bringham, M.C.Ehrhardt 2013,p.111):

$Market-to-Book\,Ratio={\frac {Market\,price\,per\,share}{Book\,value\,per\,share}}$

Examples of Book-to-Market Ratio

• Warren Buffett and Berkshire Hathaway: Warren Buffett is a famous investor and the CEO of Berkshire Hathaway, a conglomerate holding company. Buffett has long been known for his value investing style and his use of the book-to-market ratio, or BTM, to determine the intrinsic value of a company. By comparing the book value of a company's assets to its market value, Buffett is able to identify companies that are undervalued and potentially good investments.
• Apple Inc.: Apple Inc. is one of the world's largest technology companies, and its market capitalization of nearly $2 trillion makes it one of the largest companies by market value. Apple has a book value of $205 billion, which is significantly lower than its market value, giving it a book-to-market ratio of 9.7. This indicates that Apple is likely overvalued compared to its intrinsic value.
• ExxonMobil: ExxonMobil is one of the world's largest oil and gas companies, with a market capitalization of nearly $200 billion. The company has a book value of $121 billion, which is significantly lower than its market capitalization, giving it a book-to-market ratio of 1.7. This indicates that ExxonMobil is likely undervalued compared to its intrinsic value.

Advantages of Book-to-Market Ratio

The Book-to-Market (B/M) ratio is a widely used measure of value used to compare the book value of a company to its market value. The B/M ratio provides investors with insight into a company's stock price and financial health. Here are some of the advantages of using the Book-to-Market ratio:

• It can help identify companies that are undervalued or overvalued in the market. The ratio can help investors distinguish between stocks that are trading at a discount or a premium relative to their book value.
• It is a quick and easy way to compare companies in the same industry, or to compare a company's performance over time. The ratio can provide investors with a clear picture of a company's financial performance, and can be used to identify trends in the industry.
• It can be used to make more informed decisions when selecting investments. The B/M ratio can help investors identify stocks that are trading at a discount or a premium relative to their book value. This can enable investors to make better informed decisions when selecting investments.

Limitations of Book-to-Market Ratio

Book-to-Market ratio is a metric used to measure the value of a company in comparison to its market value. It is used as a measure of how much investors believe in the company's potential. However, it is important to note that it has its own limitations. Below are some of the limitations of the Book-to-Market ratio:

• It does not take into account the current market conditions or the future prospects of the company. It is based on the book value of the company which may not reflect the true value of the company.
• It does not take into account the quality of the assets held by the company. It is based on the book value of the assets which may not accurately reflect their true value.
• It does not take into account the debt held by the company. The book value of the company may not reflect the true amount of debt held by the company.
• It does not take into account the current cash flows. The book value of the company may not reflect the current cash flows of the company.
• It does not take into account the company's intangible assets such as its brand, customer base, and intellectual property. These intangible assets may have a significant impact on the company's value and are not included in the book value.

Other approaches related to Book-to-Market Ratio

Financial management includes many approaches to identify, analyze, and manage financial risks. One of the most popular approaches is the Book-to-Market ratio, which measures the market value of a company’s equity relative to its total assets. Other financial management approaches include:

• Financial Ratios: These are used to measure various aspects of a company’s performance and financial health. They can be used to assess profitability, liquidity, solvency, and efficiency.
• Risk Management: Risk management is the process of identifying, assessing, and controlling potential risks. It involves understanding the source of the risk, identifying ways to reduce it, and implementing strategies to manage it.
• Capital Budgeting: Capital budgeting is the process of allocating resources to projects and investments with the goal of maximizing returns. It is used to assess the potential profitability of a project and determine how much capital should be invested.
• Cost-Benefit Analysis: This is a type of financial analysis used to evaluate the cost and benefits of a project or investment. It helps to determine whether the costs are worth the potential benefits.

In summary, financial management involves many different approaches to identify, analyze, and manage financial risks. Book-to-Market ratio is just one of many approaches, and other approaches include financial ratios, risk management, capital budgeting, and cost-benefit analysis.

References

• Ang A., (2014), Asset Management: A Systematic Approach to Factor Investing , Oxford University Press, USA
• Beaver H.W, Correia M., McNichols M., (2011), Financial Statement Analysis and the Prediction of Financial Distress , Now Publishers Inc, USA
• Bringham F.E., Ehrhardt C.M., (2013), Financial Management: Theory & Practice , Cengage Learning, Canada
• Cakici N., Topyan K., (2014), Risk and Return in Asian Emerging Markets: A Practitioner’s Guide , Springer, USA
• Campbell Y.J., Lo W.A. and MacKinlay A.C., (2012), The Econometrics of Financial Markets, Princeton University Press, NJ
• DeFusco A.R., McLeavey W.D., Pinto E.J., Runkle E.D., Anson J.P.M., (2015), Quantitative Investment Analysis , John Wiley & Sons, Hoboken
• Kinder G., (2012), The Seven Stages of Money Maturity: Understanding the Spirit and Value of Money in Your Life , Random House Publishing Group, New York
• Peterson L.R., (2016), Trading on Sentiment: The Power of Minds Over Markets , John Wiley & Sons, Hoboken
• Seyhun N.H., (2000), Investment Intelligence from Insider Trading , MIT Press, USA
• Weil L.R., Lentz G.D., Evans A.E., (2017), Litigation Services Handbook: The Role of the Financial Expert , John Wiley & Sons, New Jersey

Author: Paulina Zając