What is the book value of a company?
A company's book value is the sum of all assets and liabilities valued at acquisition or production cost and adjusted in accordance with commercial and tax law through write-downs and write-ups. Put more simply, a company's book value represents the difference between its total assets and its total liabilities. In an alternative method, intangible assets are also deducted from total assets.
Significance of Book Value
Book values correspond largely to the sum of a company's equity. Synonyms are net book value and carrying value. The book value changes over time; the change in the respective period of time is referred to as a book gain or book loss.
The book value is a key metric in corporate valuation, i.e. for assessing the current value of the company. In a sense, it reflects the "substance" of a company. However, care must be taken here as different industries are not easily comparable, or not comparable at all.
This is partly because, for example, an IT service provider, unlike a car manufacturer, does not show expensive machinery or production halls on its balance sheet.
Particularly in difficult times, book values become an increasingly important corporate metric for many investors, as they indicate how much proceeds would currently result from the liquidation or sale of a company. This is important to consider, for example, in the event of a potential insolvency.
Difference from Fair Value
Another method for valuing assets is the so-called fair value (or current value). This is calculated as follows:
Fair Value = Acquisition cost – accumulated depreciation + value adjustment
The fair value therefore describes the actual value of an asset. Book value and fair value can also be identical, but this happens only very rarely.
Issues with the Interpretation of Book Values
Book values are certainly an important benchmark for assessing whether a company is valued "expensively" or "cheaply". One problem is that it can only be effectively compared within the same industry. However, the accounting book value suffers from several shortcomings when it comes to measuring valuation precisely.
One risk is that it can be written down at any time at management's discretion. In addition, companies can exclude both assets and liabilities from the balance sheet, so that they are not reflected in the accounting book value.
Lastly, accounting rules are designed to provide the best estimate of liquidation value for debt holders, rather than to measure the capital employed to generate returns. Yet, that is precisely what is of utmost importance to equity investors.
Hidden Reserves
One issue when looking at this is that individual deviations are difficult to take into account. This is evident, for example, when looking at hidden reserves.
Example:
When purchasing a machine worth 2 million euros, a useful life of 10 years is assumed. With straight-line depreciation, this machine will therefore have no value left on the company's books after 10 years – so this does not reflect the deprecation of the actual value performance.
However, it is of course possible that the machine will still function and be used even after 10 years. It therefore represents an asset for the company that has a positive value. This difference between the actual value of the machine and its book value is a hidden reserve.
Calculation:
Book value per share = Book value / Number of shares
Alternative:
Book value per share = Equity (excluding minority interests) / Number of shares
The Price-to-Book Ratio (P/B Ratio)
Even more descriptive is the price-to-book ratio, or P/B ratio for short. This compares the book value per share to the current share price.
For example, a low P/B ratio indicates an undervalued stock, but is not definitive proof.
Learn more here about this financial metric.