Ultra-conservative investors often consider the book value of a company before investing. You can think of the book value as the value of a company if it went out of business and liquidated all of its assets. This means that all liabilities must be subtracted since if a business goes bankrupt, debts will be paid before stockholders are compensated. It generally excludes intangible items such as goodwill and patents. Some things increase book value over time, such as the appreciation of real estate owned by a company. Some things depreciate over time, such as equipment and outdated technology. Since intellectual property is not usually included, book value has obvious limitations when it comes to evaluating service companies and technology companies. It has much more validity when considering industrial companies and companies that have vast real estate holdings, such as the railroads.
When investors are looking for underappreciated stocks, knowing the value of a company in terms of tangible assets isn’t as helpful as knowing that value in relation to the stock’s price. Investors often calculate a company’s price to book ratio (P/B ratio) for this purpose. When comparing similar companies with similar accounting practices, investors can evaluate which companies are selling cheap, and which ones are expensive. Because investors are willing to pay up for future growth, market values will usually exceed book values. This results in a P/B ratio better than one. The obvious weakness of this method of valuation is that it is based on (some would argue dated) accounting practices that see research and development costs as expenses and give them no credit to the plus side.