What is Book Value of Equity?
Book value of equity, also known as shareholder’s equity, is a firm’s common equity that represents the amount available for distribution to shareholders. The book value of equity is equal to total assets minus total liabilities, preferred stocks, and intangible assets.
Book value of equity represents the fund that belongs to the equity shareholders and is available for the distribution to the shareholders and it is calculated as the net amount remaining after the deduction of all the liabilities of the company from its total assets.
What Does Book Value of Equity Mean?
Book value is the amount that investors would theoretically receive if all company liabilities were subtracted from all company assets; this leaves a residual amount available for distribution to investors. The concept is used to establish the minimum amount that a business should be worth, which can be considered the lowest price at which the sum total of its stock should trade. The book value of equity concept is not entirely valid, since it does not account for undocumented assets and liabilities, and also assumes that the market values of assets and liabilities match their carrying amounts, which is not necessarily the case.
There are several variations on how to compute the book value of equity, which are:
- Classical approach. Simply subtract liabilities from assets to arrive at book value.
- Time-adjusted. Assets are worth less if they must be liquidated in the short term, and worth more if the seller can maximize the sale price over the long term. Thus, evaluate assets based on their long-term liquidation value, rather than their immediate “fire sale” prices.
- Going concern concept. If a business is assumed to be a going concern over the long term, its assets are worth more, because it is using them to generate more business.
- Bankruptcy concept. If a business is in bankruptcy proceedings, it can presumably negotiate lower repayment amounts on all outstanding liabilities, and may be able to terminate some contracts that would otherwise result in the generation of additional liabilities over time. However, bankruptcy nearly always eliminates all equity, so there is no residual book value for investors to be paid.
The book value of equity concept is rarely used as a measurement within a business. Its most common application is by investors on a per share basis when evaluating the price at which a publicly-held company’s stock sells.
In general, the book value of equity depends on the industry that a company operates in, and how it manages its assets. Companies that are expected to grow and generate higher profits in the future, typically have a book value that is lower than their market value, i.e. the value of the company that is determined by the stock market because they can generate relatively high profits from their assets.
Conversely, companies that are less growth-oriented and more value-oriented tend to have a book value of equity that is greater than their market value. In fact, this means that the market is not that confident in the company’s ability to generate profits in the future, but, on the other hand, value investors believe that the market is not correct.
Now, let us have a look at the advantages of a Book Value:
- It helps in determining whether a stock is undervalued or over-valued by comparing it with the market price.
- It indicates the financial health of a company, i.e., a positive value is an indication of a healthy company. In contrast, a negative or declining value is a signal of weak financial health.
Now, let us have a look at the disadvantages of a Book Value:
- Usually, the assets are carried at historical value, unless it is revalued, which is typically lower than the market value and eventually the understates the book value.
- Book value reports as part of the quarterly or annual filing. But the filings take time to publish, and as such, an investor comes to know about the book value of a company after a significant amount of time from the actual event.
- It fails to capture the impact of intangible assets because of its subjective nature of valuation.
Book value of equity is an important concept because it helps in the interpretation of the financial health of a company or firm as it is the fair value of the residual assets after all the liabilities are paid off. From the perspective of an analyst or investor, it is all the better if the balance sheet of the company is marked to market, i.e., it captures the most current market value of the assets and the liabilities.