On the surface, the term book value might appear to be straightforward. However, once you open the cover, you’ll see that it’s not as straightforward as one might think.
Table of Contents
What Is the Book Value of a Company?
In the context of assets, the definition refers to the original cost of its assets minus the accumulated depreciation. Sound complicated? Simply put, it’s the amount left over once the company sells all its tangible assets and pays its outstanding bills.
How does it change over time? Even though an asset’s value stays the same over time, a company’s book value can grow. Are you confused yet? A company’s value grows from accumulating earnings generated through asset use.
Five Second Takeaway
- It represents the value of all assets minus intangible assets, net of depreciation.
- It’s a measurement of the value of things you can touch—and that’s all.
- The book value of your investments is not the same as the market value of securities.
- Knowing the value is important to investors because it provides an overview of a company’s total worth.
- The Price to Book Value ratio can help you know you’re getting good value in buying a share.
- One of its biggest drawbacks is that it doesn’t consider intangibles.
Value of a Company Usefulness
For a few reasons. Firstly, valuation is important because it represents a fair and accurate picture of a company’s worth. Often, this value is expressed as book value per share.
So, how do you calculate that? In investing, book value is the average amount you pay for your investments. This calculation includes the costs of buying and selling, adjusted for reinvested dividends, and the cost of corporate reorganizations and distributions.
The calculation is pretty straightforward in its simplest form (absent from adjustments). Let’s turn to a real-life example to illustrate. Suppose you bought 200 shares of Google at $100 per share; the book value would be $20,000 (200 x $100).
Is It Important to Investors?
Below are a few examples of its importance.
- It lets you know if a stock is undervalued or overvalued so you can determine if you should buy, sell, or hold.
- Aids in market analysis/comparing multiple companies or stocks.
- I am understanding working capital.
- Calculating financial ratios for fundamental analysis. Examples include:
- Working capital ratio
- Debt to equity ratio
- Debt ratio
- Price to book (P/B) ratio
- Current ratio
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Book Value and Taxes
If you’re anything like me, you want to do everything possible to reduce your tax bill. Unfortunately, I wasn’t always like this and learned my lesson hard.
Several years ago, I had a lot of investments in a non-registered account, sadly with room in a registered account, and I went ahead and sold them. Unannounced to me, I’d be hit with a huge tax bill. If I took the time to calculate the book value of my investments, I’d know the capital gains I’d have to pay.
Book Value v Market Value
No, your investments’ book value (BV) is not the same as the market value of securities. The market value of a security is the most recent Price it’s trading at on the market. As most of you traders know, this Price is impacted by market fluctuations. On the other hand, BV is not affected by the rise and fall of prices in the market.
Let’s turn our attention again to the 200 shares of Google you purchased and assume the share price rises from $100 to $150. The market value of Google is now $30,000 (200 x $150), but the book value is still $20,000.
Book Value Changes
Absolutely. Take, for example, the scenario where you buy the same stock over time at different prices. If you remember, we use average prices to calculate book value. Thus, purchasing the same stock at different prices results in a book price based on an average of your prices.
For example, if you purchased 100 shares of Apple at $20 and later bought 100 more at $25, your book value would be $2,000 plus $2,500, or $4,500. The BV per share, or the average cost you paid, is $22.50 per share ($4,500 divided by 200).
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BVPS is the equity available per share to common shareholders. It’s the ratio of available common equity to the number of outstanding common shares.
The following formula can be used to calculate book value per share:
Book Value per Share = (Total Common Stockholders Equity – Preferred Stock) / Number of Common Shares.
BV = Shareholders Equity – Preferred Stock
- Shareholder’s equity = Total Assets – Total Liabilities.
Note: The average number of common shares is essential instead of the total. Why would one want to use the average number of common shares in the calculation? Mainly because any major events like stock issuances or buybacks will (likely) affect the calculation, making a stock appear over- or undervalued.
Company ABC consists of the following:
- Total assets (end of year) = $150,000
- Total liabilities (end of year) = $80,000
- Preferred Stock = $20,000
- Number of common shares = 2000 shares
Your job is to find out the book value of Company ABC.
STEP 1: Determine the total shareholders’ Equity available to common and preferred stockholders. To do that, you must use the following formula.
- Shareholders’ Equity = Total Assets – Total Liabilities
So, the shareholders’ Equity = $150,000 – $80,000 = $70,000.
STEP 2: Calculate how much shareholder equity is available to the common stockholders. To do so, deduct the preferred stocks from the shareholders’ Equity:
- Shareholders’ equity available to common stockholders = Shareholders’ Equity – Preferred Stock
So once you plug in the numbers, you’ll see that the shareholders’ Equity available to common stockholders = $70,000 – $20,000 = $50,000.
STEP 3: Then divide the shareholders’ Equity available to common stockholders by the number of common shares.
- BV per share formula of UTC Company = Shareholders’ equity available to common stockholders / Number of common shares
In this case, the calculated BVPS = $50,000 / 2000 = $25 per share.
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Limitations
Despite the many benefits of book value, the calculation does have some limitations:
Not Always Up to Date
Those who follow a company’s financials know that balance sheets are typically published quarterly or yearly. Unfortunately, investors don’t always have the latest figures to base their decisions on.
Potentially Complicated
Adjustments such as depreciation must be considered to calculate book value. In the context of book value, multiple depreciation methods can make calculations more complicated.
Exclusion of Intangibles
One of the biggest drawbacks is that it doesn’t consider intangibles. Intangible assets lack physical substance—you can’t touch or see them, but they can be used.
Intangible assets include software, design, partnerships, talent, branding, copyrights, franchises, patents, trademarks, and trade names. This makes companies that rely heavily on human capital and intangible assets difficult to value.
Growth Is Overlooked
Assets and liabilities don’t always paint a full picture. For example, companies that invest heavily in development or operate at a loss can have a low or negative book value. Unfortunately, if the figures used to calculate the price-to-book ratio, the ratio may (wrongfully) indicate that the company is undervalued or in distress.
Quality Is Overlooked
BV does not consider the quality of a company’s assets or its current market price. For those in the real estate game, you know that assets (like real estate) sometimes gain value over time. Conversely, machinery and equipment can become outdated or less reliable. In both situations, the BV may not accurately reflect the value of the assets.
Price to Book Value Ratio
To calculate the Price Book Value ratio, divide the market price of the shares by the BVPS calculated above. Since most companies trade above BV, their Price to Book Value Ratio is typically greater than 1.
Final Thoughts
As an investor, the Price to Book Value ratio can help you know you’re getting good value in buying a share. On its own, it often indicates little or nothing. However, it can back up an opinion about a stock arrived at in another way, such as the Price / Earnings (“P/E”) ratio. Combined with the P/E ratio and other analyses, the Price to Book Value Ratio can help identify bargains and help investors avoid over-priced stocks. All investors must understand the price-book value Ratio and its implications to succeed in their investing endeavors.
