What is the Significance of Book Value?
Book value is probably a common term one would encounter when we read annual reports or other financial reports. Back in one of our earlier article, Never Judge a Book By Its Covers, In This Case Book Value! we shared on how we should not take numbers on the balance sheet at face value. In this article, we will further investigate whether analyzing book value would still be useful at all.
What is Book Value?
Book value of a stock describes the value of tangible resources shown in a company’s balance sheet. These tangible assets can be fixed assets such as machinery, motor vehicles and/or factories and basically ignores goodwill, trade names, patents and franchises. The book value can sometimes be referred to as net tangible asset (NTA) and is also frequently termed the net worth of the company.
Book value of a stock is simply (common stock + reserves – intangible assets) / (number of shares outstanding)
What Investors Should be Aware of When Looking at Book Value
Companies with several machinery and equipment like a food processing company or a vessel operating company tend to have very large book values as compared to a technology company. The stated book value of a company does not represent the “real value” of the assets carried on the balance sheet. Firstly, companies account for their assets differently in various countries and industries. It is up to up to management’s discretion to estimate the useful life of a fixed asset, say a factory. For example, a PPE (property, plant & equipment) such as a machinery used for food processing can have its useful life grossly overstated, thus understating depreciation charges and increasing the net income of the company. Similarly, the salvage value of an equipment can be overstated in order to bring the same result of understating depreciation and overstating net income.
Another instance whereby the book value of a company would be different from its actual cost is when companies pay a large sum of money to build a machine but the selling value of the equipment declines faster than the company is required to depreciate the asset. If the company were to sell off the machine, it might get less than what its stated on the balance sheet (i.e. a write-down).
Furthermore, in some cases fixed assets can be reported at fair value as opposed to depreciated cost. What this means is that the asset in question can have their value “marked to market” and have valuation gains in order to avoid depreciation charges. One then have to assess whether the valuation gains/losses is fair.
Are There Any Practical Use for Book Value in Today’s Investment Analysis?
Book value allows the analyst to be able to ascertain what he/she is actually getting for his money in terms of tangible resources. Remember, a premium above book value exist because the company is able to earn a huge return on its capital but this might not be permanent as a large return attracts competition and is not likely to continue indefinitely. Conversely, a business selling at below its book value or net tangible assets could be due to its abnormal low earnings which could lead to withdrawal of competition within the industry. With the absence of old competition, economic forces would improve the company’s situation and restore a normal rate of profit on the capital investment.
Value in Action
A book value might be state its actual cost or “real value” on the balance sheet but it helps an investor or analyst to determine whether he/she might overpay for a company’s net assets.
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All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie does not own any shares in the companies mentioned above.
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