What is book value?
The book value definition refers to a company’s value or net worth that is recorded on its financial statement. Also referred to as the net asset value in the UK, it helps determine the amount of money a shareholder or investor would receive per share if a company was liquidated, selling all of its assets and paying back all liabilities.
In addition, a book value meaning can also refer to the value of a particular asset on the company's balance sheet. An asset’s book value is calculated by taking the original cost of the asset and subtracting its accumulated depreciation (the total amount an asset has depreciated in value since it was purchased).
As book value represents the intrinsic net worth of a business. It is generally used in fundamental financial analysis by investors who want to determine whether a company is overpriced or under-priced in order to take further investment decisions. Therefore, book value is an essential indicator that investors use to estimate a stock's valuation.
However, note that neither book value nor market value are unbiased estimates of a company's value.
Where have you heard about book value?
You may have heard about cars having a 'book value'. The premise is essentially the same: the book value of a car is its original value, with any depreciation over time considered. When selling your car, you are often told to aim for as close to its book value as possible, to make sure you get the best deal.
What you need to know about book value...
In order to calculate a company’s book value, the following formula is applied:
It means that a company's book value is found by subtracting its total liabilities, such as debt, accounts payable and preferred stock from its total assets, such as cash, land, buildings, computers, patents and goodwill. The value left after this calculation represents the company’s intrinsic worth.
Let us see how it works in an example. Assume a business owns total assets of $5 million and has total liabilities of $2 million. In this case, the book value of the company is $3 million. Simply put, if the company decided to sell off its assets and pay back its liabilities, the net worth of the business would be $3 million.
For an asset, the book value does not always reflect the real worth of it, as it does not impact an asset's market value.
And for stock, the same issue applies. The book value of stock is a theoretical figure of how much each share is worth. But, of course, the actual total entirely depends on the stock's market value.
Book value, when measured alongside market value, paints a useful picture of a company's real worth to potential investors.
Value investors, for example, tend to refer to book value when looking for stocks trading at bargain prices. An investor waits for the moment when a stock trades below its book value in order to buy the company's shares cheaper than what their actual worth is.
However, the potential drawback is that the company may artificially inflate the value of the assets on its balance sheet. In this situation, a discount to book value is justified and does not represent a bargain stock price.
In addition, the book value of an asset is an accounting item that is subject to adjustments, such as depreciation, amortisation or impairment costs. In turn, it may make it rather hard to understand and assess the figures. If a business has been depreciating its assets over time, an investor may need to keep track of several years of financial statements to understand its influence.
Another issue is that book value is reported on a quarterly or annual basis. Therefore, an investor would know how the company’s book value has changed over time only after the report was published.