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I would like to know whether my reasoning is correct.

Differences between market value and book value shouldn't exist in "a perfect world", since the value of a firm is whatever someone would be ready to pay for it, which is market value. In that sense, book value does not correctly reflect the value of the firm. This is due to incorrect (accounting) valuation of assets and/or debts. In "a perfect world", everything in the firm would be continually re-evaluated according to the market, and not according to past prices and/or accounting procedures. The discrepancies between book value and market value are in due to accounting procedures which do not (or not frequently enough) re-evaluate the value of the firm's assets or debt.

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No, I don't think your reasoning is correct.

The market value is just the market's averaged guess at the discounted future cash flow of the firm is. It's an indicator to current and potential future investors as to the future returns to be made from that company.

The book value is a piece of accounting that is there to give the tax authorities, the owners and the directors one form of valuation of the company's net assets.

So book value and market value differ in two ways: they have a different audience; and they are describing different things.

Some investors and analysts use the price:book ratio to compare companies within the same sector, to identify outliers, mis-pricings and warning signs - similar to how ROCE is used.

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What sense, then, is there in comparing the two (I'm thinking of the P/B ratio) –  lodhb Apr 1 '12 at 7:55
    
@lodhb I've now added a line to my answer to cover P/B ratio too –  EnergyNumbers Apr 1 '12 at 8:00
    
Thanks for your edit. So, can we conclude that 1) book value doesn't reflect the true value of the firm (which is market value), it is simply an accounting concept, and 2) P/B ratio is a measure of accounting misvaluation of assets (P/B > 1 => assets are worth more than their book value), which might give information on how the firm is managed (can extract high returns from assets) or if it is over/undervalued, and is useful in comparing different companies inside one sector –  lodhb Apr 1 '12 at 8:08
    
Sort of. But there is rarely such as thing as knowable "true value". And whether P/B is useful is a matter of opinion. –  EnergyNumbers Apr 1 '12 at 8:18

There are a lot's of factor that could affect the price of a company without appearing in its book value: growth perspective, crisis, interest rates, regulation, price of oil, management style, branding, R&D, marketing, goodwill, etc...

For example: How much is worth a marketing effort done one year ago? Does it still reward the company? How much is it worth to have well known and respected products? How much are worth clients satisfaction and how does it affect your value?

Because of that, even if we had "perfect markets" the book value will still not be equal to the market value.

Let's take ebay: it does not own more than a bunch of computers for their websites.

What is the value of the website "ebay"? How do you put it in the book value? Is it worth as much as the computers that host the website (obviously, no)? Should it be the price of the R&D effort put into the website? Without marketing no one would know what ebay is, so the marketing effort should also be taken into account?

It's very hard put a price on that kind of assets.

That is why there many methods to assess the fundemental value of a company (ie, what should be its market value). The 3 most known methods are:

Net Asset Value, which is basically the book value.

That method could work well on real estate company whose value is more or less the buildings that they own minus what they borrowed to acquire them.

Comparable analysis, where you compare companies between them to asses their prices.

Example: Some car making companies are being traded at a PER of 15. Then, if you see a car company that, all else being equal, is trading at PER of 10, you could say that its mispriced.

Discounted Cash flow, which is saying that a company is worth as much as the cash flow that it will give me in the future

If you think that a company will give some cash flows for a certain period of time, then you compute the present value of the cashflows and say that it should be its value. We can note that this pricing method takes into account growth perspectives, which is not part of the book value.

There is another well known method, a more quantitative one, this is the Capital Asset Pricing Model, its about looking at how a company should be priced relatively to a benchmark of other companies based on past statistics.

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