Analysts often compare the market value of a firm’s outstanding common stock to the reported value (book value) of common shareholders’ equity. For example, at the end of 1997, Kerr-McGee Corporation had 47,686,000 shares of stock outstanding, and the market price per share was about $63. Kerr-McGee reported total shareholders’equity at $1,440,000,000, or $30.20 book value per share ($1,440,000,000 total shareholders’ equity / 47,686,000 shares outstanding). Accordingly, Kerr-McGee’s market-tobook value ratio is computed as follows:
Market-to-book value ratio = Market price per share / Book value per share
= $63 / $30.20
Why would investors be willing to buy Kerr-McGee’s stock at over two times its underlying book value? The answer rests on the fact that the current market price of Kerr-McGee’s stock depends on the future cash flows (dividends and resale price) that stockholders expect. In this sense, market price measures the economic value of Kerr-McGee’s stock. The book value of Kerr-McGee’s stock, on the other hand, reflects the methods used to identify and measure Kerr-McGee’s assets and liabilities. Accounting measurements are based largely on historical costs and do not purport to reflect contemporary expectations about future cash flows. Despite its popularity, the market-to-book value ratio appears to be comparing apples to oranges.