Calculating Book Value with Ease
Accounting uses different measures to gauge a company’s value and comply with legal requirements.
One of the most important is book value. It is widely used internationally for varying purposes. This article explains what it is and how to calculate it.
What is Book Value?
The term derives from the accounting standard to record assets on the balance sheet or “in the books.” Put simply, book value represents the assets of a company minus liabilities owed.
This financial metric, also known as net book value or net carrying amount, shows the value at which an asset or liability is currently measured in the balance sheet. For this purpose, depreciation is deducted from the acquisition or production cost (possible write-ups are added.
Book value thus corresponds to the money equivalents at which individual items of fixed assets, i.e., property, plant, and equipment or financial resources, are recorded in a balance sheet.
In the (relatively uncommon) case that depreciation equals the actual reduction in the value of an asset, book value would be the same as fair value, which in US-GAAP is equivalent to current market prices.
On the other hand, if depreciation and amortization have been overstated, the carrying amount will be lower than the fair value, and vice versa. Therefore, the book value does not necessarily correspond to the replacement or market value of an asset.
A book profit is made when the book value is higher than the acquisition or production cost. Accordingly, a book loss exists if the fair value is lower.
If, for example, assets are sold above their current book value, this results in extraordinary income for the company.
Calculating Book Value
The starting point for calculating book value is the acquisition and production cost of an asset. Due to the valuation measures prescribed by law, this very value may change as of the following balance sheet date.
In this context, depreciation, i.e., the amount by which the value of an asset is reduced over time in the balance sheet, is of crucial importance. In purely formal terms, the book value is therefore calculated as:
Or, expressing the same in simpler terms:
However, book value is not necessarily limited to the assets side of the balance sheet. Sometimes it is also determined for liabilities. As a rule, the book value in such cases corresponds to “amounts outstanding.” In the case of liabilities, this means the remaining debt to be settled.
To assist you with the calculation of book value there are helpful online tools like the Asset Book Value Calculator on AccountingPortal.com.
What does Book Value Tell You?
Book value is essential for a company’s truthful valuation because it is considered an accurate representation of what a company is worth. In that regard, the metric serves two main functions.
1) The book value of a company corresponds to the equity on the balance sheet date. It, therefore, does not include any liabilities – such as loan receivables – but the value of all cash deposits plus equipment, real estate, etc., which the company owns.
Put differently, book value thus shows how much a company would be worth if it were liquidated. It is the amount shareholders of the company would receive.
2) In the case of publicly traded companies, book value is commonly compared to the market value to determine if a stock is fairly priced (meaning it is not over or underpriced). That can be particularly relevant for value investors who look for companies with significant growth potential and stocks that are (still) undervalued.
In short, book value is one of the most important tools to find out what a company is really worth. However, there is one type of asset book value frequently misses. That problem is discussed in the next section.
Shortcomings of Book Value
The principal flaw of the metric book value has to do with intangible assets. Companies may have such intangibles or immaterial assets, like patents or intellectual property. Although they are difficult to account for, they can be of great value to the company.
The specifics will depend on what kind of business a company is. Put simply, ideas and inventions will be more critical to a company developing software than to a firm that trades with, say, scrap copper and other metals.
The problem with book value and intangibles lies in the difficulty of accurately accounting for immaterial assets. By their very nature, it is difficult to find a fair price for them to be put on a balance sheet.
The result may be that a company’s market valuation far exceeds its book value because the market is taking valuable intangibles into account. In such a case, although market value is higher than book value, the shares of the company may not be overvalued. Book value then would underrepresent what the business is, in fact, worth.
So, the lesson for investors is that book value may not be a reliable guide for their decisions. Instead, they have to rely on their own judgment as to what value the intangible assets of a company may have for the business.
The Bottom Line
Book value is the principal metric to determine what a firm is worth by subtracting liabilities from assets. Net book value is thus the equivalent of the equity of a company.
Therefore, book value is widely used by stock market investors looking for a bargain. They do that by comparing book value to market valuation. If book value is greater, chances are that the stock is undervalued, representing a buying opportunity.
However, one drawback to be kept in mind is that book value insufficiently accounts for intangible assets like patents. So, investors should take other indicators in addition to book value into account as well.
If you want to calculate book value, go to this online Net Book Value Calculator.