The book value of equity per share can be calculated by:
Total book value of equity divided by Number of ordinary shares outstanding
The book value per share can be used to determine if a company is undervalued or not. This is of course compared to the price per share. If the price per share is trading below the book value of the company, the company may be undervalued. Indications that the company is undervalued include a growing earnings per share, dividend paid and an increased free cash flow over the years.
However at times when the price per share trades below the book value per share of the company, there is a good reason for it to be so. These reasons include a declining market share, profits, earnings per share and reduction in dividends paid over time. In instances such as these, these may be called value traps.
However, by and large, if you have a portfolio of stocks trading at less than book value, the portfolio will tend to do well, provided they do not fall into the category of a value trap. If you are looking to buy options on stocks trading at less than book value, focus on stocks which are trading at a price to book of less than 0.5 and are profitable and irrationally beaten down. You will find much more success there than anywhere else.
Growing book value
Companies that grow their book value over time are creating value for their shareholders. Companies with decreasing book value over time are destroying value.
SunEdison Inc is a company that has been making losses for many years.
Looking at the total equity row, one will find that the total equity has declined over the last 5 years in general. Incidentally, SunEdison has not been creating value for its shareholders.
Let us examine another company called Wells Fargo.
The total equity has grown from 1.4 billion to around 1.9 billion for 5 years. This is an example where the company is creating value for its shareholders.
How option traders can use this information?
Option traders can use bullish option strategies on value creating companies or bearish strategies on value destroying companies. Value creating companies often increase in book value. An example of a value creating company is Coca Cola. Companies that create shareholder value usually are stable in price and whose prices have a general upward bias.
As you can see Coca Cola’s share price ranged from $40 to $45 over the past 5 years. So for an income investor, he may want to write covered call options on this stock, earning premium over time. Read: General Overview Of Covered Calls
Sometimes, during a recession, book values do not fall by much but share prices fall to such an extent that they trade at less than 0.5 times of book value. In time like those, an investor or a trader may want to bet on buying call options in anticipation of a recovery.
There are so many strategies. This is only a glimpse of how a trader or an investor can use book value.