Investor Education: Book Value Has Little Meaning

The same goes for stocks, which some investors find attractive when they trade at prices low compared with earnings or assets.

One common valuation measure is book value, which is basically the net worth of a company as shown on its balance sheet.

You can compute that figure by taking the difference between a company's assets and liabilities, and then dividing that number by shareholders' equity.

The basic idea is to buy stocks trading below their book value per share, hoping they'll grow to reflect the full value of the company.

Although popular, this method of picking stocks hasn't served investors well.

Investing is not that easy. A firm with a book value of 50 a share trading at 25 should not automatically be deemed a buy.

Book values judge a company's value through accounting rules.

However, market prices reflect a firm's potential; Wall Street is always looking ahead.

The market is the final arbiter in establishing stock prices, not book value.

A number of home builders are trading well below their book values, but a closer inspection will make investors think twice.

Dominion Homes (NasdaqGM: - ) is trading at a big discount to its book value. However, it has lost money for five straight quarters and analysts are expecting more losses. The stock has dropped sharply, to about 4 from above 40 in March 2004 amid a slump in the housing market.

Research shows that valuations such as book value or price-to-earnings ratios are of little use.

Most winning stocks had costly valuations when they began their major price advances.