The meaning of the book value is to display the liquidation value of the enterprise. In case of bankruptcy, all assets or part of them goes under the hammer to cover liabilities to creditors, and the rest is divided among shareholders. It is believed that intangible assets, such as patents and brand, are difficult to evaluate and sell upon liquidation. However, does book value reflect intrinsic value?
The book value of assets (net tangible assets) is the equity capital of the company minus all intangible assets and goodwill. It is easy to calculate, because all the raw data are in annual or quarterly financial statements.
Book value formula
Shareholders’ equity is total assets of a company minus total liabilities. The calculation formula is as follows:
The formula for calculating book value is as follows:
According to this formula, we get net tangible assets that can be seen and touched. Intangible assets, such as patents, brand, goodwill, etc. – are excluded as intangible.
Many investors incorrectly calculate this value. Equating it to the company’s equity, without deducting intangible assets and goodwill.
Examples of calculating the book value
Let’s calculate the book value of assets for 3 public companies: Boeing Co, Apple Inc and Wells Fargo. The data is taken from the annual financial statements for 2017:
|Boeing Co||Apple Inc||Wells Fargo|
Please note that Boeing Co has a negative book value. This means that total liabilities exceed total tangible assets by $7.77 billion.
Benefits of book value for investors
The book value of assets is useful in assessing the profitability of enterprises. Good enterprises have an after-tax return on book value of 15–25%, adjusted for inflation. The formula for calculating return on book value:
There are also value investing strategies that buy undervalued stocks at a price 30–50% lower than book value. With the possible liquidation of an enterprise, the investor loses almost nothing, because he is protected by margin of safety in in the form of a high discount relative to the book value. Valuation formula:
If the value of Book Yield is 2, then the company’s stocks are traded at a price 2 times lower than the book value (the discount is 50%).
- Good for financial institutions such as banks, insurers and reinsurers. In such structures, almost all assets and liabilities are highly liquid and have a market value comparable to the book value;
- Allows you to separate companies that have tangible assets, from companies whose basis – intangible. In the second, the profitability of the book value will be much higher than in the former;
- Allows you to identify acquirers who love to acquire other businesses. In such structures, the return on book value will be negative or positively high.
- Poorly suited for non-financial companies, where the real value of assets and liabilities may differ from the book value. For example, on balance, machines cost $10,000, but in reality, they can hardly be realized for $1,000. This is true in the opposite direction, when the real value is much higher than the book value. In case 2, there are investment strategies looking for companies with an undervalued book value;
- Does not account for intangible assets. Many enterprises have few tangible and many intangible assets. For example, consulting and information technology, which earn on sales of intellectual property. Also medical, whose products are protected by patents. At comparable sizes, such companies will have a book value lower than that of oil, mining or construction enterprises;
- Does not take into account the brand. The strength and value of a brand of some companies can be enormous. Coca-Cola, Apple, IBM, American Express, Nike, etc. – the value of these brands is enormous. Promotion and brand awareness stimulates sales and customer loyalty.
When used properly, book value can help in evaluating businesses. For completeness, it is highly desirable to use this indicator in conjunction with others.