Elsewhere, I have explained the difference between how book and market capitalization is calculated. There won’t be space to repeat that explanation at length here.

Suffice it for now to say that the book price is the value that a company’s accountants and executives attach to its equity – derived by total liabilities subtracted from total assets. The market price is the valuation that traders in the company’s shares arrive at through the market exchange process. (For more detail on how these numbers are derived, see the link at the bottom of this article.)

Relatively speaking, book value is stable. That, though, doesn’t mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.

The reasons behind the stock market’s erratic fluctuations must await another discussion. For the moment we are only concerned with the fundamental reasons underlying discrepancies between book and market capitalization, as well as their relevance to investment strategy.

Putting those reasons aside, just briefly, the basic principle involved is simply that the market – by which, of course, we mean the buyers and sellers of companies‘ shares, through constant bid-ask operations – hits upon prices disputing the equity value that the company assigns its own capitalization.

The market capitalization may be more or less than the book value. There are plenty of potential reasons for this. Sometimes it is merely a matter of brand. If, for whatever reason, the company brand is highly regarded, product Y produced by it may simply be more highly valued by consumers than a Y produced by a company with a lesser brand.

If this results in consumers willing to pay a brand premium for the product, capital otherwise hardly distinguishable from competitors effectively becomes more valuable. In such situations, obviously, there is no dispute about the literal book value of the company’s assets. Nonetheless, though, further considerations may lead share traders to value the shares more than suggested by the book value.

Many discrepancies, however, are indeed a function of markets disagreeing with the stated book value of a company’s assets. An example would be the situation in which a company’s assets include undeveloped land. If the market, and the company’s accountants, has valued the assets at prevailing real estate rates a potentially dramatic divergence of value could result if enough share traders re-evaluate the land. Say, for instance, they become convinced that the region in question is poised for a major real estate boom. At that point traders may now consider the land a significantly undervalued asset on the company’s books.

Recognizing such undervalued shares sufficiently in advance is a means to great profits. Those who have early enough recognized the situation bid on the company’s shares in great numbers. The more shares one can purchase at the undervalued price the more total profit one stands to make whether the long term intent is to resell at the higher price or collect the increased dividends expected. In the process, of course, this raised demand for the shares pushes up their price. The resulting market capitalization value is thus increased considerably over the book value.

It can likewise work the other way around. If the company is in a business which a large enough number of share traders become convinced will soon be subject to new, onerous regulation that will entail massive compliance costs, their conclusions could be that the company’s book value of its equity insufficiently accounts for its actual liabilities. The shares are considered overpriced and shareholders start lowering prices to unload them and cut their losses.

Thus, though there are numerous potential explanations, the discrepancy between book and market valuing of a company’s capitalization reflects the market’s doubt about the company’s book value. Understanding what this doubt is and whether it is soundly based is the key to an investment strategy that leverages market capitalization against book value.

The illustrations above provide plenty of different manners in which diverse skills and insights can aid in such leveraging: e.g., familiarity with the real estate market, the government’s legislative agenda or popular taste. Possessing insight into any of these matters, or numerous others, can provide the opportunity to benefit from a book value that inadequately appreciates the true or immanent value of a company’s equity. When you discover such a discrepancy the opportunity for profitable investment – whether under or overvalued – is available.

This is how understanding the difference between book and market value, and the process of market capitalization, is essential knowledge for investors. If this all presumes a knowledge about market capitalization with which you don’t feel acquainted, please read my What is Market Capitalization article.

Investors who want to benefit from misvalued book equity need to follow the hottest scoop at the Market Capitalization site. Wallace Eddington is a widely published commentator on markets and finance. His recent piece on fiat currency and inflation is a must read for those looking to make sound monetary investments.