Book value refers to the accounting value of an asset or company. The book value of an asset is its cost minus any depreciation. The book value of a company is the total value of all its physical assets, which excludes any intangible assets, minus its liabilities. In both cases, the book value is essentially the sale value for physical assets, less any associated costs or obligations.
Book Value Examples
Imagine that Company A owns one building that it purchased for $100, the purchase was partially funded with a loan of $50 and the building depreciates in value by 10% each year.
The book value of the building after 1 year would by $90, which is the purchase price of $100 reduced by 1 year of depreciation at 10%.
The book value of the company after 1 year would be $40, which is the book value of the building at $90 less the value of the outstanding loan of $50.
Book Value and Historical Cost
It relies on the use of historical cost and depreciation to value physical assets, which are accounting techniques that often fail to capture the true value of an asset. The value of assets can change based on market demand and supply, shifting technologies and complex forms of depreciation, all of which traditional accounting practices fail to capture.
Companies may use an alternate process known as ‘mark-to-market’, which attempts to identify a current market price for physical assets based on looking at similar assets that have recently been transacted on the open market. This process is generally considered to give a more accurate valuation of assets than book value, when appropriate market examples are available.
The Importance of Book Value in the Pricing of Companies
The concept of book value is very important to trading in equities. A company’s book value is essentially its liquidation value if all its physical assets were sold tomorrow and all company liabilities covered. Therefore, any equity for the company should, theoretically, at the very least equal or exceed the book value of a company.
One of the most popular metrics for evaluating a company is to examine its market price relative to its book price.
A company that is trading near or below its book value is a signal that something is wrong with how the company is being run. A company that is trading below its book value is essentially destroying value by operating, and would be worth more as a simple collection of physical assets than an organized company that is attempting to employ those assets to create a profit.
However, a company with a low relative market value compared to book value may present an excellent buying opportunity as the company only requires some small tweaks to its organization or strategy to unleash a large amount of value. Investors that seek out companies with suppressed market values are using ‘event-driven’ strategies, and also often include activist investors who will look to directly influence the operation and management of a company.
Conversely, companies that trade at a high relative market value to book value are often the favorite targets of short sellers, as these valuations may be based on overly optimistic estimates for growth or the values of intellectual property holdings.
Book Value and Trading
Most traders who use this metric in trading use the price-to-book (P/B) metric to compare companies within a sector. Since companies with similar operations facing similar circumstances should have very similar price-to-book values, any outliers are likely to present an opportunity for profitable trading.
There is a wide variety of different approaches for exploiting price-to-book ratios that are out of the ordinary, but they all seek to profit from a reversion of the ratio toward sector standards.
Final Thoughts
Book value is an effective means of identifying a rough estimate of the value of physical assets and companies, particularity when no adequate markets exist for establishing mark-to-market values. However, relying too heavily on book values can lead to poor decision-making, as they are not always an accurate reflection of true value.
The concept of book value is useful when trading, as major divergences in price-to-book ratios among companies in the same or similar sectors often present a variety of different trading opportunities.