When valuing a company, there are many metrics to consider. And while most of them show a clear picture of the organization’s worth from a sales and revenue standpoint, it’s also important to consider how much intrinsic value it has. That is, its book value.

What is book value? If you take all the liabilities a company has and subtract them from the assets and common stock equity of the company, you’re left with book value. Most of the time, this is an evaluative measure, rather than an assessment of the company’s market value. Nevertheless, it’s an important baseline metric to understand. It sets the floor for the company’s value and represents its worth if business ceased and the company liquidated itself tomorrow.

Here’s how to use book value and why it’s worth considering as an analytical metric when evaluating a company. 

What Does Book Value Represent?

Book value is the bottom-line worth of the company in the event of liquidation. It considers the leftover value after selling off all tangible assets to pay back all outstanding debts. The formula for calculating this value is exactly that: assets minus liabilities. For example…

ABC Company has $500 million in tangible assets, in the form of production equipment, facilities, vehicles and other on-the-books assets. The company also has debt of $480 million in the form of short-term loans and notes. The company’s book value is $20 million ($500 million – $480 million = $20 million).

Keep in mind that book value doesn’t represent intangible assets, such as intellectual property. The best way to identify tangible assets and liabilities is to look at the balance sheet. An up-to-date and accurate balance sheet will paint a clear picture of the company’s assets and liabilities. 

It’s also important to realize that this value isn’t an accurate picture of company health on its own. It’s best used as a benchmark against market value or in conjunction with other valuation metrics. 

Book Value vs. Market Value

There’s an important comparison to make between a company’s book value and its market value. While book value represents intrinsic value – the amount each shareholder would get if the company liquidated – market value represents the company’s value based on total outstanding shares (market cap). 

There’s often a significant difference between book and market value. This is because market value encompasses investor profitability, investor sentiment, future growth prospects and more. Where book value represents bottom-line worth, market value is a real-time metric that accounts for demand. Market value rises or falls daily, based on what investors are willing to pay for equity shares. 

Book Value per Share

Book value per share (BVPS) divides the book value of a company by the total number of outstanding shares. This represents how much each share is worth in the event of a liquidation and how much each shareholder would receive relative to their shares. For example…

ABC Company has $150 million in shareholder equity on the balance sheet and 25 million outstanding shares. Its BVPS is $6 per share ($150 million / 25 million = $6 million).

BVPS is often different from the current share price of the company, as determined by the market. This is where the price-to-book ratio comes in as an evaluation metric. 

What Is Price-to-Book Ratio?

Many investors put book value and market value side by side in a metric called price-to-book ratio (P/B). To calculate this ratio, divide the current price per share by the book value per share. 

If the ratio is 1-to-1, it means an equal valuation between book and market values. A ratio of less than one means the book value is higher than the market value – a sign that the market has undervalued the stock. A ratio higher than one can mean the market overvalued the stock. 

Keep in mind that this ratio doesn’t exist in a vacuum. Most stocks have a P/B well over one because investors account for the profitability and cash flows of a business when investing in it. They’re willing to pay a premium for a company showing signs of growth. That said, P/B over 3-to-1 signals an overvalued stock.

The true value of the P/B metric is as a value investing tool. Companies with a P/B of less than one that have a relatively healthy balance sheet could be candidates for correction when the market values them appropriately. 

The Drawbacks

While book value is a great tool for setting valuation benchmarks, it’s more of an accounting standard than an investment metric. It’s reported only when companies release their quarterly financial data, which means balance sheet figures may not be accurate a month or two after the fact. Moreover, if a company depreciates an asset, investors may not understand the impact to book value – even in the event of straight-line depreciation. 

Book value can also skew depending on the company’s current financial position relative to its assets. For example, book value for an asset may be $2 million; however, if a company files for bankruptcy, creditors may liquidate that asset for $1 million. Moreover, if a company has liens against its assets, the balance sheet may not reflect this accordingly, inflating book value. Finally, some assets simply have arbitrary values due to their nature – intellectual property, for example. 

Like most other financial evaluation metrics, book value isn’t a hard-and-fast standard. It’s often a moving target and one that’s best used to contextualize other metrics, like market value. 

A Metric for Company Valuation

By itself, book value is a way to get to the bottom of what a company is worth based on the sum of its assets. In a more valuable application, book value can tell investors many things about a company relative to how the market values it. It’s not a difficult metric to calculate, and every investor should get into the practice of recognizing book value as they perform due diligence on a company. It’s an illuminating metric that can shed light on hidden investment opportunities. To learn more about the latest trending stocks, sign up for the Profit Trends e-letter below. The experts at Profit Trends do the research for you so that you can find new additions to your growing portfolio!