Market Value vs. Book Value of Equity Securities

Market Value vs. Book Value of Equity Securities

The book value of a company’s equity shows the historical decisions made by its management in operations and financing. In contrast, the market value of the company’s equity not only includes these decisions but also represents investors’ collective evaluations and outlook on the company’s future cash flows from positive net present value investment opportunities.

Book value focuses on a company’s past, while market value considers its future. If a company has a high price-to-book (P/B) ratio compared to industry peers, it suggests the market expects significant growth for that company.

Comparing P/B ratios between companies in different industries doesn’t make sense because market prices also account for the growth potential of entire industries, which can vary greatly.

Question

$$
\begin{array}{l|r}
\textbf{Company} & \textbf{P/B} \\
\hline
\text{Toyota} & 1.25 \\
\text{Ford} & 1.58 \\
\text{Tesla} & 11.65\\
\end{array}
$$

Based solely on the P/B ratio, which auto company is likely to have the least attractive opportunities for growth?

  1. Ford.
  2. Tesla.
  3. Toyota.

Solution

The correct answer is C.

Because Toyota has the lowest current P/B ratio, the market is placing the lowest value on the company’s future growth opportunities. On the other hand, the market has high growth expectations for Tesla.

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