A firm's accounting book value is the difference between its total assets and total liabilities. This is otherwise known as Shareholders equity. Tangible book value refers to the company's total equity minus intangible assets such as patents and goodwill. Both of these measures can be calculated from the Balance Sheet.
Book value serves as a reference for a number of key reasons:
- Accounting book value is the value that shareholders would receive if the firm was to be liquidated.
- It can be used to measure the company's ability to consistently achieve a return on their shareholders equity.
- Book value serves as a reference point for companies who are expanding their economic footprint, for example as they open new stores and acquire new logistical facilities.
Book Value versus Market Value
While book value refers to the accounting measure of a firm's net worth, the company's intrinsic value may differ substantially from its tangible worth. This depends on a number of factors, such as the company's returns on equity, return on assets, growth prospects, liabilities and operating sector. Generally firms which earn high returns on equity who are seen to have favourable future prospects will trade substantially above book value, while firms who earn lower returns and are seen to have uncertain futures may trade below book value. Companies that trade at their book value are considered to have earning power only equal to their assets.
Book value is essentially what has been invested into the firm, while a firm's net income is its ability to generate earnings from what has already been invested. Since most companies are expected to grow their earnings over time, firms generally trade above book value. Growth companies for example, may trade as high as 10 times their tangible book value. Using book value is a more useful metric to evaluate companies who are growing slowly or expecting to sell their assets.
Conclusion
Book value is a useful reference point for managers looking to assess the net worth of their firm. The importance of firm's book value depends on its ability to generate returns and the industry in which it operates.
