Why do market value and book value of a firm differ?

The distinction between market value and book value lies in their fundamental definitions and the factors they consider. Market value represents what investors are willing to pay for the firm at a given time, reflecting real-time perceptions of value based on current market conditions and future growth potential. In contrast, book value is primarily based on the accounting value of a company’s assets, calculated using historical costs, which do not take into account appreciation, inflation, or future earnings potential.

The reason why market value and book value often differ significantly is due to the dynamic nature of the market as opposed to the static nature of the book value, which is rooted in the price the firm originally paid for its assets. This means market value can encompass more diverse factors - such as market trends, investor sentiment, and anticipated future earnings - that are not captured in the historical accounting practices that determine book value.

Understanding this difference is crucial for investors and stakeholders as it provides insight into how the market values a firm relative to its accounting measures and can indicate potential investment opportunities or areas of concern regarding a firm's current financial health and future growth prospects.