Book Value

What is the book value?

Book value of the company is a residual amount after subtracting total liabilities from the total assets given in the balance sheet. Alternatively, it also refers to the equity in the balance sheet of the company. Equity in the balance sheet includes share capital, reserves and retained earnings. 

It is hardly the case that liability and assets are equal, and there is always a mismatch, which is matched by the equity. Moreover, the value of equity in the business is also referred to as the book value of the enterprise. The balance sheet equation suggests the below: 

What is the book value per share?

Book value is usually expressed on a per-share basis, which is calculated by dividing book value by the number of shares outstanding. It is extensively used in the corporate finance world and forms the denominator for the price-to-book value ratio. 

Book value per share = Book Value/ Number of Shares Outstanding

Why is book value important?

It is used in determining the intrinsic value of the business. Through book value, the price-to-book value ratio is calculated that forms a basis to determine whether the stock of the company is available at a good pricing point or not. 

Companies trading at a discount to their book value are often considered underappreciated by the market. Alternatively, a discount to book value means when the market capitalisation of the stock is lower than its book value. 

On the basis of multiples, the discount to book value will appear when the stock has a P/B ratio below one. Investors also compare P/B ratios of similar companies to determine which stock is relatively underappreciated compared to its peers. 

Value investing strategy, along with other metrics, considers the book value of the stock extensively while making investment decisions. Value investors tend to target companies that are trading at a discount to book value or relative discount to peer companies, with expectations that the target company is poised to grow.

Intangible assets and book value 

One of the downsides of the book value is that it accounts for the intangible assets, which if taken independently from the business may not yield similar utility. Intangible assets include assets like patents, copyrights, licences, trademarks, intellectual property etc. 

Although intangible assets may not attract a high degree of attention in asset-heavy businesses, they are crucial in companies that are asset-light models and have large intangible assets. 

Consider a software developing company having a very low tangible asset base and a high intangible asset base. Market participants may reward the company with high multiples of P/B ratio, irrespective of the fact that business has very low tangible assets. 

Book value vs market value 

The market value of the company is derived from the market forces. Since the price of the stocks continues to fluctuate during the trading sessions, the market value of the company also fluctuates consistently with the changes in price. 

Market value is also called market capitalisation of the company. It is calculated by multiplying stock price and the number of shares outstanding. When the market value is higher than the book value, it means the market is giving premium to the book value of the company. 

Likewise, when the market value of the company is lower than the book value, it means a discount to the book value. This discount may also indicate that investors have weaker expectations from the company. 

What is the tangible book value?

Tangible book value of the business is calculated by subtracting intangible assets from the book value of the firm. Since the book value of the firm also includes the value of intangible assets in the balance sheet, the tangible book value reflects that value that could be extracted in the event of a liquidation. 

When companies have preferred share capital in the equity, the book value of the firm will be subtracted by the cost of preferred share capital. Although some preferred shares have no fixed maturity date, they can be redeemed on the sole discretion of the company. 

What is the tangible book value per share?

The tangible book value of the firm is divided by the number of shares outstanding to calculate tangible book value per share. It reflects the amount per shareholders in the event of liquidation of the firm. 

What is the price-to-tangible book value ratio?

The ratio is expressed as the price relative to tangible book value per share. It is similar to price-to-book value, but the ratio takes tangible book value per share instead of book value per share of the company. 

It provides an idea of how much is being paid for an interest in the company in return for the value of the company that would be available for equity shareholders in the event of a liquidation. 

Why is tangible book value important?

In the event modelling extreme downside risks in an investment, the tangible book value gives a clear picture of the expected value in the business left for equity shareholders after paying all its obligations. 

It is an effective measure for companies having large tangible assets with minimal intangible assets. In a real scenario, it would be difficult to extract the same value for assets that are recorded in the balance sheet. 

When in liquidation, it is possible the resale value of tangible assets could be lower than the reported value in the balance sheet. At the same time, there remains a possibility that the assets could be sold at a premium to reported value in the balance sheet. 

Evaluating companies based on tangible book value could give an inappropriate picture for a business that thrives on large intangible assets such as technology companies, software developers, pharmaceutical companies, franchisee companies licensing brands etc.