June 2, 2010 - For many investors the answer is elusive. They sort of know what a stock is but when pressed they don't fully understand what it is they're buying when they decide to invest. Usually they respond with something like: "I'm buying a company." And that's right. But specifically, here's what they're buying.

Book Value is the amount of earnings that a company has compiled over the years. Most companies lose money for a while before they become profitable. When they do, Book Value tells you how much the company has retained in the business, the profits. As a company grows its profits, Book Value increases as those profits are added on to previous earnings. Book Value per share is calculated by dividing the total number of shares outstanding into the Book Value. Book Value is easily found in almost all quote programs. It's labeled Book Value.

Book Value reflects what stockholders own. It's theoretically what a company is worth at a moment in time if all debts were paid, all assets were sold, and there was nothing but cash left. That cash would then be distributed to shareholders. As an owner of the company, even if you own 1 share out of 200 million, you would get your percentage of the proceeds.

As an example, let's say a company has $100 million in Book Value and 10 million shares outstanding. Book Value per share would then be $10 (100/10). If the company stopped business, sold everything, then paid its debts, it would have $100 million to distribute. That money would be divided among all shareholders, and if you owned one share of stock, you would receive $10. There would be some discrepancy because not all buildings and equipment would sell for their value on the books, but you get the idea.

So here's the first thing a wise investor would want to do: buy stocks that are selling below Book Value. It's like buying dollar bills at a discount. Say the company above was selling for $8 a share. If the Book Value, what you own, is worth $10, then you are already $2 ahead. Of course, you don't want the company to stop doing business, but if it did, you'd make out very well. Sometimes stocks sell for less than half Book Value. The lower you can buy the stock below Book Value, the better your chances are of making money.

Of course, the easy part of research is knowing the Book Value. That's history. The hard part is finding stocks with growing earnings that will increase Book Value. There are stocks you can buy below Book Value that are increasing earnings. It doesn't seem to make economic sense, but they're out there. You just need to do a lot of research to find them.

When something seems so obvious, you have to ask: why would a stock sell for less than Book Value? Most often, it's because investors believe the company will lose money in the future, therefore, decreasing Book Value. Or the company is in an industry that is out of favor during the current economic cycle. That creates opportunity for investors who have done their research and have price levels established that let them buy a stock below Book Value. And when their stocks get to those levels and have good earnings prospects, they put in their Buy orders.

- Ted Allrich