Why Book Value can’t be the perfect floor price of a company? Is there any better measurement? What is the way to compute that better option/s?
Author:- Sonia Taneja(NIT Kurukshetra)
Before
answering the statement that book value can’t be the floor price, let us first
know what the book value is:
Book Value:
Book value is the value at which the assets and liabilities are mentioned in
the financial statements of an entity. In the book value, the values of the
assets are mentioned after deducting the depreciation from them and goodwill is
not mentioned. For example, if in an entity, there is machine worth Rs. 600,000
and its life has been estimated for 10 years and every year it is depreciated
at 10% in the straight down method.
In
every year, 60,000 will be deducted from the assets value and remaining value
would be mentioned in the balance sheet’s asset side for the 10 years and in
the 11th year, the value asset would be nil.
Now
let us understand what the Floor Price is:
Floor Price: Floor
price is the minimum amount at which the assets of an entity are being sold out.
Now,
let us answer the question that why Book value can’t be the floor price for a
stock. There are various reasons behind it. These are:
1. As
the market price can‘t fall below the floor price, but we have studied earlier
that book value can be zero also. Apart from that, book value is the purchased
value of an asset in first year and in further from it, the depreciation value
is being deducted. When the market price of an asset is fallen or increased, it
is not mentioned in the book value. It is the reason book value can’t be the
floor price. For example, we might see in 2012, Microsoft’s book value per
share even was less than the market price. When book value is reduced, it is
done to exempt the taxes and it is increased to attract the investors but the
actual position of an organization is different from the current market price.
2. Another
reason is the book value is mentioned on the basis of historical concept, but
the value of assets changed, they don’t remain as the value on the time of
purchase, that’s just a history.
3. Book
value can’t be the floor price due to the reason of not mentioning the value of
good image of an entity. As many a times happen, the value of goodwill is not
mentioned in the financial statements. So, book value can’t be floor price as
it doesn’t represent the value of all assets and also not the accurate values
of all of the assets.
4. Market
price represents an entity on the basis of current value of the assets but book
value doesn’t. That also shows book value can’t be set as floor price. It
usually not happen that market price is equal to the book value.
So,
these were the reasons that Book value can’t be the floor price for a stock.
Now
let us discuss about the alternatives of book value to be used as Floor price:
The
first better option to be set as floor for a stock can be Liquidation value per share.
1.
Liquidation
value per share: This can be one of the best
tools for measuring the floor price as this involved the end amount left with
an entity after breaking up the all entity and selling out all the assets and
repaying all the liabilities. This can be best for measuring the floor price as
it would be good for an entity even if there is market price below this amount
as all the liabilities have been paid already and there is no responsibility
leftover and still if there is amount left that can be paid to the shareholders
but if it is not left or the market price goes below this value, that would be
good sign for an entity and that entity would be still attractive for the
investors. In this, it is checked that after selling out the whole business,
what will be left or nothing will left is checked out.
How to calculate Liquidation value per share:
Liquidation
value per share can be calculated in this way:
Let
us take an example to understand this:
Let
say there is co. named XYZ Ltd. Whose balance sheet seems like this:
|
Assets |
Amount |
Recoverable value ( after Liquidation,
Market value of assets) |
|
Current
Assets: Cash and cash Equivalents Inventories Debtors Marketable Securities |
50000 40000 30000 20000 |
100%
= 50000 60%
= 24000 40%
= 12000 80%
= 16000 |
|
Fixed
Assets: Land & Building Furniture Machinery |
100000 60000 50000 |
80%
= 80000 60%
= 36000 40%
= 20000 |
|
Total Assets |
350000 |
238000 |
|
Liabilities |
Amount |
There is no need to calculate market
value of liabilities as we have to bear all the liabilities |
|
Current
Liabilities: Creditors Trade Payables |
50000 30000 |
|
|
Long
Term Debts: 10% Non convertible debentures |
80000 |
|
|
Shareholders’
funds 5% Preference Shares Equity shares( 15000shares of Rs. 10
Each |
60000 150000 |
|
Now,
for Computing the Liquidation Value, we need to deduct Current and long term liabilities
and payment of preference shares from the market price of assets, remaining
part would be left for the equity shareholders
Thus,
238000-(50000+30000+80000+60000) =
16000
Thus,
Liquidation value per share = 16000/ 15000 = 1.06
And,
the Second better option to be set as floor price is Replacement Cost.
2.
Replacement
Cost: This is also a good source to
be set as floor price as it includes the entity must have sold the assets which has
been valued at the historical prices and new assets to be purchased at the
current value to know the accurate market price of the assets and as per the
various analysts also that the market price can’t be much differentiated from
the replacement cost for the longer period as if it will happen like market
price of any asset has been increased , then the competitors will enter in the
market to get benefit out of it. So , replacement cost can also be a good floor
price to be set on.
Let
us take an example to understand this:
For
Example, TPQ is a plastic manufacturing Company which manufactures 1 lac
plastic bottles in a year and they are using the 5 machines from last 10 years and
let assume the cost of each machine to be RS. 10000.
Thus,
the total cost of machines would be Rs.50000.
So,
now if company wants to know about the replacement cost of its machines, it
will be calculated in the following manner:
The
current market price of each required machine is Rs.18000
So
the replacement cost of 5 machines would be = Rs 5*18000 = Rs. 90000
*Company must take the
decision about the replacement after comparing the replacement cost with the
Net present value at the current time from last 15 years, what is the value of
Rs.50000 spent ten years back.
In these ways, we can conclude about how Book value should not be set as the floor price and what are the options available to be set as floor price.
Thank you
Comments
Post a Comment