Table of Contents
What is book value?
The book value of an asset refers to the net difference between a company’s total assets and its total liabilities where it is the representation of the total value of a company’s assets that shareholders will receive when the company liquidates. It is equal to the cost of carrying an asset in a company’s balance sheet. We can refer to the book value as the net book value (NBV) or net asset value of a firm.
In other words, book value refers to the value of a company’s equity as it is reported in the financial statements. A company views it in relation to the stock value or market value (market cap) of the company.
Here, firms calculate it by netting the company’s total assets against its accumulated depreciation. This makes analysts see the book value as the net asset value of a company. Investors and analysts calculate the book value by subtracting the intangible assets such as patents and goodwill, and liabilities from the total assets. This metric may net or gross expense which includes trading costs, sales taxes, charges for services, etc., for an investment’s initial outlay.
For the book value per share, firms calculate it by dividing the total number of a company’s common stockholder’s equity and subtracting the preferred stock by the common shares of the company.
In essence, the book value is the accounting value of the assets of a company minus all claims that are peculiar to common equity such as the liabilities that accrue to the company. The word book value originated from the accounting practice of recording the value of an asset at its original historical cost in the books.
While an asset’s book value may remain unchanged over time, based on accounting measurements, a company’s book value can grow collectively from the accumulation of earnings that the company generated through the use of the asset. Since the book value of a company represents the worth of shareholding, comparing the book value with the market value of shares tends to serve as an effective technique of valuation in the course of trying to decide whether the fair pricing of shares took place.
Book value calculation
Calculating the book value has to include the following factors;
- Add original purchase price
- Add the additional expenditure subsequently charged to the item
- Subtract accumulated depreciation
- Subtract impairment charges
- Finally, this brings about the book value
Companies usually do not include the BV in their stock listings or online profile. So one has to look at the financial statements and all the assets and liabilities in the balance sheets to find the BV of a company. Just as the emphasis is when you sum up all the assets and subtract liabilities, the result is the BV.
Book value formula
Expressing the BV in a formula, a company calculates the financial metric as;
Book value = Total assets – Intangible assets – Liabilities
Example
A manufacturing firm spends $150,000 to purchase a machine and the company subsequently spends an additional $25,000 aimed at expanding the machine’s production capacity. The was a total charge of $ 45,000 as an accumulated depreciation against the machine as well as an impairment charge of $20,000. Let us look at the calculation;
Total asset = $150,000
Additional expenses = $25,000
Accumulated depreciation = $45,000
Impairment charge = $20,000
Therefore;
BV = ($150,000 + $25,000) – ($45,000 + $20,000)
= $175,000 – $65,000
BV = $110,000, based on the principle above.
In the calculation above, the additional expense on the machine was added to its original expense less accumulated depreciation and impairment charge. By implication, depreciation is also an expense since the asset loses its economic value with time, in the course of constant usage. In the question above, there were no intangible assets. If there were, we would have subtracted it also.
Book value of equity
The book value of equity refers to the amount of common equity of a firm or a company that is available for distribution among shareholders. It is equal to the number of assets that shareholders outrightly own after paying off all the liabilities.
Generally, the industry under which a company operates has a significant influence on the owner’s equity of a company. Also, another influencing factor is the company’s ability to manage its assets and liabilities. As a matter of fact, the thumb rule is that the companies that have the likelihood to generate and perform well and earn higher profits are the ones whose book value is lower than their market value.
A company calculates its BV of equity by adding the capital contribution of owners, treasury shares, retained earnings, and other incomes accumulated. The formula is as follows;
Book value of Equity = owner’s contribution + Treasury shares + Retained earnings + Accumulated other incomes
Components of the book value of equity
We can break down the BV of equity into four basic components which are as follows;
- Owner’s contribution
- Treasury shares
- Retained earnings
- Other comprehensive income
Owners contribution
The owner’s contribution encompasses the common stock and additional paid-in capital. The common stock refers to the equity capital that is at par value of shares while the additional paid-in capital is the excess of capital over an above the par value.
Companies sometimes buy back some of the floating shares as part of corporate strategy. However, the company does not cancel these shares that were repurchased but holds them back instead as treasury shares in their books of account.
Retained earnings
Retained earnings refer to the portion of a company’s profit that has not been paid off to shareholders in the form of dividends. Usually, it is accumulated for a while if the performance of the company is excellent and this forms part of the company’s equity.
Other comprehensive income
Primarily, other comprehensive income includes net income as per the profit and loss statement alongside other accumulated comprehensive income of the previous years.
Uses and importance of book value
As a firm’s accounting value, the book value has two major uses;
- It serves as the total value of the company’s assets that shareholders would theoretically receive at the liquidation of the company.
- When we compare it to the market value of a company, the financial metric can indicate whether a stock was overpriced or underpriced.
The BV, BVPS, the price-book ratio, and other related ratios are so much useful to potential investors especially when it comes to the issue of overpricing or underpricing of stock. These metrics are major determinants of investors because they reflect the company’s value.
The BVPS is a figure that represents the financial strengths of a company on the basis of its assets. We consider it to be important in terms of business valuation because it is a representation of a company’s fair and accurate picture in its worth. In other words, market analysts and investors get a reasonable idea of the worth of a company.
Also, if an investor is using a value investing strategy, then book value is primarily important for him. This is because it can enable him to find bargain deals on stocks especially if he has a suspicion that the company is undervalued or poised to grow, and the stock will rise in price. Any investor that is able to grab stocks while the costs are still low in relation to the BV of the company is in an ideal position to make a significant profit as well as be in a good trading position.
Limitations
A major limitation of the book value is that it fails to accurately account for intangible assets that are of value within the company such as patents, goodwill, and intellectual property. By implication, investors need to be wise and observant, taking into consideration the type of company and industry it operates. Also, it is difficult to accurately ascertain book value when mark to market valuation is not applicable to assets that are bound to experience fluctuations in their market value, that is increase or decrease.
When a company’s book value appears to be too high or too low compared to its market cap, it may not necessarily indicate whether a stock is undervalued or overvalued but rather the fact that the bulk of the assets are intangible in their form.
Book value per share refers to the ratio of equity that is available to common shareholders divided by the number of shares outstanding. This figure is a representation of the minimum value of a company’s equity, it, therefore, measures a firm’s book value on the basis of per-share. In other words, the BVPS takes the ratio of the common equity of a firm and divides it by its number of outstanding shares.
The BVPS is an effective indicator of a firm’s net asset value (that is total assets minus total liabilities) on a per-share basis.
Investors use this financial metric to gauge whether the price of a stock is undervalued by comparing it to a firm’s market value on the basis of per share. If a company’s BVPS exceeds its market value per share (its current stock price), then analysts consider it to be undervalued. If the BVPS of a firm increases, we are to perceive the stock as more valuable, and therefore, the stock price should increase proportionately.
Theoretically, the BVPS is the sum that shareholders would acquire at the liquidation of the firm when they sell all the tangible assets and pay all the liabilities. However, as the company would sell all the assets at market prices, and the book value uses the historical costs of assets, we consider the market value as a better floor price than BV for a company.
On the other hand, if the share price of a company falls below its BVPS, a corporate raider would make a profit that is risk-free by purchasing the company and liquidating it. If BV turns out to be negative where the liabilities of a company exceed its assets, then we refer to this as a balance sheet insolvency.
The formula for calculating BVPS is as follows;
BVPS = Shareholders’ equity – Preferred stock / Average outstanding shares
Example
A private limited liability company has $20 million of shareholders’ equity. Out of this equity, $5 million are preferred stocks. The average outstanding shares that the company has during this period is 3 million shares. Calculate the BVPS using this information.
The calculation of the BVPS will be as follows;
BVPS = ($20,000,000 – $5,000,000) / 3,000,000
= $15,000,000 / 3,000,000
BVPS = $5
Another way of determining the BVPS is by dividing the number of common outstanding shares into the total equity of stockholders.
For example, if in the balance sheet, the shareholders’ equity section contains the sum of $1,000,000 and there are 200,000 outstanding shares, then the book value will be;
BV = $1,000,000 / 200,000
BV = $5
The BVPS and MVPS are tools investors use in evaluating the value of a company’s stocks. However, they do not mean the same thing.
The reasoning with regard to this is that the book value per share is a representation of a company’s financial strength on the basis of its assets, an objective number. On the other hand, the market value per share is a representation of how attractive a company’s shares are in the marketplace, a subjective number.
While financial analysts calculate the book value per share using historical costs, the market value per share is a financial metric that aims at looking at the future earnings of a company. By implication, an increase in the potential profitability or an expected growth rate of a company should lead to the increase of the market value per share of the company. So, the book value per share is not a forward-looking metric and this makes it not reflect the actual market value of a company’s shares.
Depreciation
Depreciation refers to the reduction in the economic value of an asset. It is an accounting method a company uses to allocate the cost of a fixed asset (physical) over its years of useful life or life expectancy. Depreciation is a representation of how much a company has used an asset. The act of charging depreciation for assets helps a company to generate revenue from the assets while charging an expense on a portion of its cost each year of the asset’s use. Failure to account for depreciation can have a great effect on the profit of a company. Companies can as well charge depreciation on long-term assets for the purpose of both tax and accounting.
It is mostly through the depreciation of assets that we arrive at the net book value. To do this, analysts subtract all accumulated depreciation from the historical cost of the asset in question. Accumulated depreciation is the sum of all depreciation that a company recorded on an asset for a specific period of time.
Net book value (NBV)
Net book value is the amount showing the worth of a fixed asset in the accounting books of a business. When a business purchases a fixed asset, it records the cost in the balance sheet which is what it owns. However, if the business wants to sell the asset, it will not get the same price for it. In this case, the business will have to reduce the amount of the asset that is worth to the business by means of depreciation.
Here, the original cost of the asset less depreciation, the result brings about the net book value. We can express it as;
NBV = Cost – Depreciation
For example, a business bought a plant and machinery for $100,000 two years ago and depreciated the asset using the straight-line method at 25 percent. The depreciation will then be $100,000 x 25 percent. This will be $25,000 each year.
At the end of the second year, the net book value of the asset will be $100,000 – ($25,000 x 2) = $50,000.
Frequently asked questions
How do you define book value?
The book value of an asset refers to the net difference between a company’s total assets and its total liabilities where it is the representation of the total value of a company’s assets that shareholders will receive when the company liquidates.
What is included in book value?
The items included in the book value are the original purchasing price of an asset, impairment charges, accumulated depreciation, expenses, and liabilities.
What is a book value in math?
Book value is simply the cost of an asset minus its accumulated depreciation. The mathematical expression is;
NBV = Cost – Depreciation