The book value of a company is all of its material assets with the deduction of its liabilities, and the book value of an asset is its present value on the (balance sheet) books.
Book value is the amount a company assigns to an asset on its books (financial records). When a firm buys an asset, the purchase price is the book value. The asset may become less valuable as it is used. If the asset is a capital expenditure (something that will be used for many years), its value is usually depreciated i.e., decreased each accounting period. Its book value becomes its original cost less accumulated depreciation and any impairment (other significant decrease in value). The book value is not necessarily the same as the market value (at which the asset will be sold). And it also does not include intangible assets such as patents or brand recognition.
Imagine you own a small IT company and buy computers, each for $1,000. Today, your balance sheet lists one computer as an asset with a book value of $1,000. Over the next year, employees will use those computers every day. They will have scuffs, scratches, and worn parts. You know, a used computer isn’t worth what it was last year. So it shouldn’t be a surprise when the book value of the asset drops to $900. The remaining $100 is called depreciation (a decrease in value due to depreciation). The purchase price minus depreciation is the book value.
What is a book value?
Book value can be applied to an asset or a company. For an asset, book value is the purchase price minus any decreases in value. These can include accumulated depreciation (an accounting process of decreasing the value of an asset over time) and impairment (a permanent accounting decline where the value of an asset decreases more than depreciation).
Not everything a company buys has a book value. Small purchases are often recorded as expenses rather than as assets because they are consumed in the process. But other purchases, especially large purchases, have value over a longer period. Known as capital expenditures, they must be amortized in a company’s books over many years. Examples may include computers, copiers, automobiles, and commercial real estate .
The formula for depreciation depends on the type of asset. Three general formulas:
- Straight-line: reduces the value of an asset by the same amount each year over its useful life.
- Units of production: decreases the value of an asset based on how often it is used.
- Double-decreasing balance: decreases the value of an asset by a larger fraction in previous years and by a smaller fraction later.
What is the purpose of book value?
Book value gives investors a better idea of how much a company’s assets are worth. If a company simply kept the purchase price of fixed assets (items used over several years) on its books, it would inflate the value of the company. Just as a used car is not worth as much as a new one, the value of equipment declines as it is used.
A company’s book value tells investors how much the company could be worth if it sold all of its tangible assets and used the proceeds to pay off its debts . In theory, this is how much shareholders would get back if the company went into liquidation. It is an estimate of the value of the company based on its accounting records, not how much investors are willing to pay for it. Comparing a company’s book value to its market value can help investors assess whether its stock is undervalued or overvalued.
The difference between book value, fair value and market value
There are several ways to determine the value of a company, stock or assets:
Book value in a business context refers to the total value of a company’s physical assets minus its liabilities.
Fair value is the amount an investor, owner, or analyst assigns to something. It is a subjective estimate (an educated guess) of how much a company, stock, or asset would be worth in the open market.
Market value is how much someone actually pays for something. It is the price determined by the market, in other words, the buyer and seller concerned. When an asset is sold, its market value is determined. At that point, it is taken off the balance sheet and the sale price goes on the income statement . The market value can be higher, lower, or equal to the book value.
How to calculate it
1. To determine the book value of individual assets, start with the purchase price (also called basis cost). Then subtract all depreciation up to that point. If an asset has undergone some unusual depreciation, it may also be impaired.
Book Value = Purchase Price – Accumulated Depreciation – Impairment
2. The book value of a company is essentially its net worth :
The book value of a company = total assets – intangible assets – total liabilities
If the company had $7 million in physical assets and owed $2 million, its book value would be $5 million.
To get total assets, add up the book value of all the company’s fixed assets. Also include cash, cash equivalents, inventories, investments, and other assets that are not depreciated. Do not count intangible assets, such as brand awareness or patents. Liabilities include loans the company has taken out, bonds it has issued, amounts it owes suppliers, and other debts. Essentially, the book value of a company is an estimate of what would be left if the owners sold its tangible assets and used the proceeds to pay off liabilities. It is sometimes called the book value of equity.
3. To calculate the book value per share, first determine the book value of the company. Then divide the book value of the company by the number of outstanding shares of common stock .
Book value per common share = (total assets – intangible assets – total liabilities) / number of common shares outstanding
What is a good book value?
If a company has a negative book value, it indicates that it has more liabilities than assets it can use to pay them off. In general, it may indicate a potential problem. The company may be over-indebted (holding too much debt) and at higher risk of bankruptcy .
Good book value is usually determined by comparing it to the market value of the company. This measure is called the price-to-book ratio:
P/B ratio = Price-to-book / Book value of stock