What is book value? | Investment advice
When evaluating a business, many parameters must be taken into account. And while most of them show a clear picture of the value of the organization from a sales and revenue perspective, it’s also important to consider its intrinsic value. That is, its book value.
What is book value? If you take all the liabilities of a business and subtract them from the assets and common stock of the business, you end up with the book value. Most of the time, this is an evaluative measure rather than an assessment of the market value of the business. Nonetheless, it is an important baseline metric to understand. It sets the floor of the company’s value and represents its value if the activity ceases and the company goes into liquidation tomorrow.
Here’s how to use book value and why it’s worth considering as an analytical measure when valuing a business.
What does the book value represent?
Book value is the equity of the business in the event of a liquidation. It considers the remaining value after the sale of all tangible assets to pay off all overdue debts. The formula to calculate this value is exactly as follows: active less passive. For example…
ABC Company owns $ 500 million in tangible assets, in the form of production equipment, plant, vehicles and other book assets. The company also has $ 480 million in debt in the form of loans and short-term notes. The book value of the company is $ 20 million ($ 500 million – $ 480 million = $ 20 million).
Keep in mind that the book value does not represent intangible assets, such as intellectual property. The best way to identify tangible assets and liabilities is to look at the balance sheet. A current and accurate balance sheet will paint a clear picture of the assets and liabilities of the business.
It is also important to realize that this value alone is not an accurate picture of the health of the company. It is best used as a benchmark against market value or in conjunction with other valuation metrics.
Book value versus market value
There is an important comparison to be made between the book value of a business and its market value. While book value represents intrinsic value – the amount each shareholder would get if the business were liquidated – market value represents the value of the business based on total shares outstanding (market capitalization).
There is often a significant difference between book value and market value. This is because market value encompasses investor profitability, investor sentiment, prospects for future growth and more. Where book value represents net worth, market value is a real-time measure that takes into account demand. The market value rises or falls on a daily basis, depending on what investors are willing to pay for stocks.
Book value per share
Book value per share (BVPS) divides a company’s book value by the total number of shares outstanding. This represents how much is each share worth in the event of liquidation and how much each shareholder would receive in relation to their shares. For example…
ABC Company has $ 150 million in equity on the balance sheet and 25 million shares outstanding. Its BVPS is $ 6 per share ($ 150 million / $ 25 million = $ 6 million).
BVPS is often different from the company’s current share price, as determined by the market. This is where the price to book ratio comes into play as a valuation measure.
What is the price-to-book ratio?
Many investors place book value and market value side by side in a measure called price / book ratio (P / B). To calculate this ratio, divide the current price per share by the book value per share.
If the ratio is 1 to 1, it means an equal valuation between book and market values. A ratio less than one means the book value is greater than the market value – a sign that the market has undervalued the stock. A ratio greater than one may mean that the market has overvalued the stock.
Keep in mind that this ratio does not exist in a vacuum. Most stocks have a P / B well above one because investors consider a company’s profitability and cash flow when investing in it. They are willing to pay a premium for a business that is showing signs of growth. That said, a P / B greater than 3 to 1 signals an overvalued stock.
The true value of the P / B metric is as a valuable investment tool. Firms with P / B below one and relatively healthy balance sheets could be candidates for a correction when the market values them appropriately.
While book value is an excellent tool for establishing measurement benchmarks, it is more of an accounting standard than an investment measure. It is only reported when companies release their quarterly financial data, which means balance sheet numbers may not be accurate a month or two after the fact. Additionally, if a company depreciates an asset, investors may not understand the impact on the book value, even with straight-line depreciation.
The book value may also vary depending on the current financial position of the business relative to its assets. For example, the book value of an asset may be $ 2 million; however, if a company files for bankruptcy, creditors can liquidate that asset for $ 1 million. Additionally, if a company has liens on its assets, the balance sheet may not reflect it accordingly, inflating the book value. Finally, some assets simply have arbitrary values because of their nature – intellectual property, for example.
Like most other financial measurement measures, book value is not an absolute standard. This is often a moving target and is best used to contextualize other metrics, such as market value.
A measure for the evaluation of the company
In itself, book value is a way to determine the value of a business based on the sum of its assets. In a more interesting application, book value can tell investors a lot about a company compared to how the market values it. It’s not a difficult measure to calculate, and every investor should practice recognizing book value when performing due diligence on a business. It is an illuminating step that can shed light on hidden investment opportunities. To find out more about the latest trending stocks, subscribe to the Profit trends e-letter below. The experts of Profit trends do the research for yourself so you can find new additions to your growing portfolio!