Determining whether a listed company is worth its salt is a complex task. Investors and analysts use several measures to reach a fair valuation of a company to reckon whether that valuation is appropriately reflected in its share prices. Often multiple measures are employed for the purpose, and one of them is book value.
Booking value, more commonly known as book value, is an organisation’s worth according to its Balance Sheet. In another sense, it can also refer to the book value of an asset that is reached after deducting the accumulated depreciation from its original value.
For instance, if a piece of machinery costs Rs. 2 lakh and its accumulated depreciation amount to Rs. 50,000, then the book value of that machinery would come about to be Rs. 1.5 lakh.
The book value of an organisation is computed after netting the aggregate book value of all the assets against its intangible counterparts and liabilities. In a roundabout way, it is the book value of shareholder’s equity.
Why this is so important to investors is because it provides a concrete knowledge of a company’s value if all its assets were to be liquidated and all liabilities settled. Common shareholders are at the bottom rung when it comes to payout in the event of liquidation of an organisation. Thus, its book value portrays the amount such investors ought to receive at any point in time.
Book value is calculated by taking the aggregate value of all its assets and deducting all the liabilities from it. Assets include both current and fixed assets, and liabilities include both current liabilities and non-current liabilities.
Therefore, the book value formula can be expressed as:
Book value = Total Assets – Total Liabilities
In some practices, investors and analysts exclude intangible assets when evaluating book value, since, their value cannot be realised during the liquidation of a business. In that case, the book value formula would be expressed as:
Book value = Total Assets – (Intangible Assets + Total Liabilities)
Book value example – The balance sheet of Company Arbitrary as of 31st March 2020 is presented in the table below.
Particulars | Amount (Rs.) |
Assets | |
Current Assets | |
Accounts Receivable | 60,000 |
Inventories | 45000 |
Cash and Cash Equivalents | 25,000 |
Fixed Assets | |
Property, Plant, and Equipment | 4,50,000 |
Land and Buildings | 3,50,000 |
Total Assets | 9,30,000 |
Liabilities | |
Current Liabilities | |
Accounts Payable | 50,000 |
Short-term debt | 70,000 |
Non-current Liabilities | |
Long-term debt | 6,00,000 |
Other non-current liabilities | 50,000 |
Total Liabilities | 7,70,000 |
Therefore, the book value of Company Arbitrary would be the difference between its total assets and total liabilities.
Book value = Rs. (930,000 – 770,000) = Rs. 160,000
Thence, if this company were to be liquidated on 31st March 2020, all its shareholders would be entitled to receive a portion of Rs. 160,000, according to their stake in that organisation.
A metric that investors use with regard to book value is BVPS or Book Value of Equity per Share. It takes the net value of a listed company’s assets, also known as shareholder’s equity, and divides it by the total number of outstanding shares of that organisation.
It is a more common metric used by investors to determine their share of earnings if a company were to liquidate all its assets and settle all claims. The book value per share formula can be expressed as:
BVPS = Shareholder’s equity or Net value of assets / total number of outstanding shares
Example: The value of Company ABC’s total assets stand at Rs.10 lakh as of 1st May 2020. The aggregate value of all its liabilities amounts to Rs.6 lakh. The total number of outstanding ABC stocks is 10,000.
From the above figures, ABC’s shareholder’s equity comes about to be Rs.4 lakh. Since the total number of outstanding shares of the company is 10,000, its book value of equity per share would be, BVPS = 400,000/10000 = 40
However, investors should note that finding BVPS in isolation cannot produce promising analysis. It can be used in conjunction with other metrics like Discounted Cash Flow (DCF) and Price-to-earnings ratio (PE) to reach a somewhat concrete view of an organisation’s potential.
The price-to-book value ratio, also known as the price-equity ratio, is also derived from the book value of an organisation. It is used widely by value investors. P/B ratio shows the relationship between a company’s market capitalisation and its book value.
P/B ratio formula is expressed as:
P/B ratio = Market capitalisation / Net value of assets
Market capitalisation is the product between the total number of outstanding shares of an organisation and its current market price.
Example: The balance sheet of Company BCD shows its total assets to be Rs.15 lakh, and the value of its total liabilities amount to Rs.9 lakh. On the other hand, its stocks are trading at a market value of Rs.62 and it has a total of 10,000 outstanding shares.
Hence, its market capitalisation is Rs.6.2 lakh (62 x 10000) and its shareholder’s equity or net value of assets is Rs.6 lakh (1500,000 – 900,000).
Therefore, P/B ratio = 620,000 / 600,000 = 1.03
Some investors go for the per-share approach, thereby dividing the shareholder’s equity by the number of outstanding shares, i.e. BVPS.
Ergo, the P/B ratio formula can also be expressed as:
P/B ratio = Market price per share / book value per share
Book value is a highly essential component in the determination of whether a company’s share prices are justified or not. Therefore, value investors extensively rely on the book value of an organisation and its associated metrics like BVPS and P/B ratio.
A P/B ratio below 1 often indicates that a company’s stocks are undervalued since its market capitalisation is lower than its book value. Similarly, a high P/B ratio might imply that a company’s stocks are overvalued.
However, it shall be noted that there is no single P/B ratio that can be considered as ideal for investments. A host of factors are at play at any point in time that can affect the P/B ratio of a particular company, sector, and even industry. Therefore, common and fundamental parameters must first be sorted out before using this ratio as a basis for investment decisions.
Moreover, book value per share or BVPS at any point of time elucidates the shareholders concerning the book value of share they are holding regardless of its market price. Based on that, they can gauge whether stock prices will go down or up in the future.
Any organisation reports its Balance Sheet quarterly or annually. Therefore, investors remain in the dark about the book value of an organisation in the in-between periods. Basing decisions on past figures can lead to inappropriate analysis.
According to conventional accounting approaches, most assets’ values are represented as per their historical figures. It does not account for the actual depreciation and appreciation in values of assets but instead is based on set accounting principles. This phenomenon creates a discrepancy and compromises analysis based on book value.
Companies or industries that extensively rely on their human capital will have an inappropriate reflection of their worth in their financial statements. Therefore, book value is not an apposite measure in these cases.
Book value is the worth of a company based on its financial books. Market value is the worth of a company based on the perceived worth by the market.
If the market value of an organisation is higher than its book value, it implies that the stock market is assigning more significance to its stocks. It might be due to its enhanced earnings, well-founded and sound management, or any other factor that buoys its market worth.
If the book value of a company is higher than its market value, it indicates that the stock market is less confident in the organisation’s earning capability, albeit its book value might. That can also come about due to a host of negative factors.
Evidently, the book value of any organisation plays a vital role in the determination of its worth. It comes forward as a critical agency for investors to base their investment decisions.