What is Book Value?
Definition: Book value of equity is a financial metric that refers to the amount that investors receive when all liabilities are subtracted from company assets. The metric tries to outline the minimum amount that a business is worth. Likewise, book value indicates the amount that investors and creditors would receive upon company liquidation.
Different measures are relied upon to arrive at a fair valuation of a business or a company. Book value of equity is one of the metrics that investors use to make informed decisions about their investments.
The book value of equity may not necessarily reflect the actual worth of a company or business. For instance, the value of assets may be much higher than what is represented in the books of accounts. Assets such a land tends to appreciate with time, and their worth could be higher than the original cost.
Investors use book value equity to ascertain and evaluate the price at which a company stock should sell. Likewise, it is rarely used within a business. The financial metric is influenced by the industry in which a company operates, as well as its ability to manage assets and liabilities.
Companies likely to perform well and generate more profits are ones that have a book value that is much lower than their market value.
Book Value Formula Calculation
The book value formula is calculated as follows:
Book Value = Total Assets – Total Liabilities
Assets, in this case, include items like cash, short-term investments, inventories, plant, and equipment. Companies with lots of machinery as well as equipment boost of large book values compared to companies engaged in services provision that mostly relies on human capital. Liabilities, on the other hand, may include things like short and long-term debt as well as differed taxes and account payables.
Computation of book value is straight forward as companies outline their assets as well as liabilities in their quarterly financial statements. In some situations, it’s reported on the financials as stockholders’ equity. Similarly, you can divide book value by the total number of outstanding shares to get another financial metric dubbed book value per share.
While the classical approach involves subtracting liabilities from assets, a time-adjusted model assumes assets are less worth overtime. Likewise, assets are evaluated based on their long-term value rather than an immediate sale price.
The going concern approach, on the other hand, assumes that assets are worth more given their ability to generate more business.
Book Value Pros
Book value of equity is an ideal financial metric for ascertaining if a stock is undervalued or overvalued upon comparing it with the market price. The financial metric, when studied, can also provide insights into the financial health of a business.
A firm with a positive book value that is consistently increasing affirms robust financial health. Declining financial health, on the other hand, should be a warning sign of weakening financial health.
Book Value of Equity Limitations
Just like any other financial metric, one cannot base their investment decision purely on the book value of equity of a company. The fact that the metric is reported quarterly or annually means an investor cannot know how the metric has changed over the months.
Considering assets are subject to depreciation, it may be challenging to ascertain the actual book value. Investors may have to check several financial statements when dealing with companies with assets that depreciate significantly.
Book value is also not a reliable financial metric when dealing with companies that rely heavily on human capital. Gaming, trading and consultancy companies rely purely on human capital that may be hard to value as compared to heavy machinery and equipment.
Book value of equity at times falls short as it does not take into consideration undocumented assets and liabilities. The fact that the financial metric assumes market values of assets and liabilities match their carrying amounts may present many challenges.