Why the market pays 2.5 times book

Two numbers for the same company

At 31 December Prairie Sky’s balance sheet shows total shareholders’ equity of $3,450,000. On the same day its 300,000 common shares close at $24.25 on the TSX. Two different people would value the company at two very different numbers, and the midterm asks you to compute both and explain the gap.

Book value per common share

Book value is the equity in the accounting records — assets at historical cost less depreciation, minus liabilities. But not all of it belongs to the common shareholders. Prairie Sky has $500,000 of preferred shares, and (from lesson 4.5) $40,000 of preferred dividends in arrears that must be paid before common shareholders see a cent. Both come off the top:

Total shareholders' equity          3,450,000
Less: preferred share capital        (500,000)
Less: preferred dividends in arrears  (40,000)
                                     ---------
Equity attributable to common       2,910,000
÷ common shares outstanding           300,000
Book value per common share             $9.70

$$\text{BVPS}=\frac{\text{Total equity}-\text{Preferred equity}-\text{Arrears}}{\text{Common shares outstanding}}=\frac{2,910,000}{300,000}=9.70$$

The denominator is shares outstanding — not authorised, not issued. If the company held any reacquired shares, they would be excluded because they have no claim on equity.

Market value

Market capitalisation is what the market says the whole common equity is worth: $24.25\times 300,000=7,275,000$. The price-to-book ratio compares the two: $24.25÷9.70=2.50$. The market values Prairie Sky’s common equity at two and a half times its accounting value.

Why the gap

Three reasons, all of which the midterm wants named:

1. Historical cost. Book value carries assets at what was paid for them, less depreciation. Prairie Sky’s office building was bought fourteen years ago; its book value bears no relation to what it would fetch.
2. Unrecognised internally generated intangibles. The company’s most valuable assets — its scheduling software, its hospital relationships, its engineers — were built rather than bought, so accounting standards forbid recognising them. They are on the market’s balance sheet, not the accountant’s.
3. Expectations. Book value looks backward at transactions that have happened. A share price discounts future cash flows: the US expansion is in the price and cannot be in the books.

When the market pays less than book

Suppose the price fell to $9.00, below the $9.70 book value. The market would be saying the company’s recorded assets will not earn their carrying amounts back. Under IAS 36, a market capitalisation below the carrying amount of net assets is an explicit external indicator of impairment — the board must test the assets for a write-down (lesson 3.3). Market below book is not merely a bargain signal; it has an accounting consequence.