Book value is a company’s equity value as reported in its financial statements. The book value figure is typically viewed in relation to the company’s stock value (market capitalization) and is determined by taking the total value of a company’s assets and subtracting any of the liabilities the company still owes.
Below is the Book Value Formula:
The company’s balance sheet also incorporates depreciation in the book value of assets. It attempts to match the book value with the real or actual value of the company. Book value is typically shown per share, determined by dividing all shareholder equity by the number of common stock shares that are outstanding.
Importance of Book Value
Book value is considered important in terms of valuation because it represents a fair and accurate picture of a company’s worth. The figure is determined using historical company data and isn’t typically a subjective figure. It means that investors and market analysts get a reasonable idea of the company’s worth.
Book value is primarily important for investors using a value investing strategy because it can enable them to find bargain deals on stocks, especially if they suspect that a company is undervalued and/or is poised to grow, and the stock is going to rise in price.
Stocks that trade below book value are often considered a steal because they are anticipated to turn around and trade higher. Investors who can grab the stocks while costs are low in relation to the company’s book value are in an ideal position to make a substantial profit and be in a good trading position down the road.
The Issue of Intangibles
Book value’s inescapable flaw is the fact that it doesn’t accurately account for intangible assets of value within a company, which includes items such as patents and intellectual property. What does this mean for investors? It means they need to be wise and observant, taking the type of company and the industry it operates in under consideration.
For example, consider a value investor who is looking at the stock of a company that designs and sells apps. Because it is a technology company, a major portion of the company’s value is rooted in the ideas for, and rights to create, the apps it markets.
The company could be trading much higher than its book value because the market’s valuation takes into account the company’s intangible assets, such as intellectual property. The stock, then, isn’t really overpriced – its book value is lower simply because it doesn’t accurately account for all the aspects of value that the company holds.
Book value is a widely-used financial metric to determine a company’s value and to ascertain whether its stock price is over- or under-appreciated. It’s wise for investors and traders to pay close attention, however, to the nature of the company and other assets that may not be well represented in the book value.
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