Determining book value is one approach to evaluate a stock’s worth. Here is a basic overview of book value and what it means in today’s market.
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What is book value?
A good definition for a company’s book value is the value of the stockholders’ equity on its most recent balance sheet, according to Mark P. Holtzman, professor and chair of the accounting department at Seton Hall University. Book value is calculated by subtracting an asset’s accumulated depreciation from its cost.
One divides the stockholders’ equity by the number of common shares outstanding to determine book value per share. In some circumstances, book value is imperative. Risk management expert Gary Patterson explained, "The IRS and state taxing authorities want historical less fluctuating book value for tax bases. Legal documents between partners, vendors and unions want the stability of book value."
Difference between book value and market value
A misconception would be that book value and market value are the same. The fair market value includes additional value—not listed on a company’s balance sheet—that investors perceive the company to have.
Holtzman points to Apple as an example of this difference. “Apple’s market value today is $545.9 billion. Its book value is $90.054 billion. That means investors are assigning Apple $455.846 billion in additional value.” The difference was determined by simply subtracting Apple’s market value from its book value.
Why did investors perceive Apple to have more value than the equity shown on its balance sheet? Many factors come into play; isolating one absolute determinate isn't possible.
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“This could be goodwill (customers love Apple)," Holtzman said. "It could be market power (everyone wants an iPad or iPhone). It could also be undervalued assets on Apple’s balance sheet (maybe the company’s Cupertino campus appreciated in value and is worth a lot more than it is recorded for on the balance sheet). It could be expectations of future earnings. It could also be irrational.”
Some common mistakes people make in determining book value can be easily avoided. Holtzman said people should use the most recently-prepared balance sheet and use total stockholders’ equity, excluding only preferred stock, if a company has any outstanding.
Limitations of book value
“Quite frankly, people shouldn’t take book value too seriously,” Holtzman said. “Stock values are driven more by expectations of future earnings than by the actual assets and liabilities of a company.”
Therefore, book value is not the most effective way to determine a stock’s worth. As Holtzman demonstrated, it can prove particularly misleading when discussing high tech companies with few investments in real tangible assets.