Book Value and Adjusted Book Value Methods
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What is Book Value (and Adjusted Book Value)?
The book value represents the value that the company based upon the internal financial statements. Specifically, book value concerns the total value of company assets minus the total value of company liabilities. This amount will equal the owners equity in the firm and, likewise, equals the book value of the firm.
Adjusted book value is the most common variation of the book value method. This method looks at the value of a company in terms of the current market values of its assets and liabilities. Another popular variation is the book value plus the value of the firms goodwill. This method focuses on the net earnings that are not attributable to a tangible asset of the firm.
The firms earnings attributable to goodwill are multiplied by the growth rate of the firm for each year that the goodwill is expected to be present. This amount is then added to the companys book value. Yet another variation on the book value calculation is the book value plus the capitalization of excess earnings.
This method values the company by combining the company's book value, the value of goodwill, and the capitalization of the company's earnings.
Capitalization of earnings is the average net earnings for a designated number of years, divided by a growth rate that represents the average rate of return for similar businesses. The capitalization of earnings methods is discussed in greater detail below.
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Issues with Book Value
The most important detriment of the book value method is that it uses accounting numbers to derive a firm valuation. Often the book value does a very poor job of representing the value of the assets to the public. This is particularly true in companies that have lots of physical assets, such as equipment. Book value is likely most appropriate in financial holding companies where the book value represents the liquid holdings of the company. The adjusted book value is more suitable than the book value, as it accounts for the actual value of physical assets. Both of these methods are deficient in that they poorly demonstrate the value of intellectual property, human capital, and company goodwill. While some versions of book value attempt to value intangible assets and goodwill, valuing these individual assets are very difficult due to lack of liquidity. This method is most appropriate when the individual assets are more important than the value of the firm as a going concern. This may be the case in the event of company mergers or break-up and sale transaction. Further, understanding the attributable value of each asset may assist the business in acquired loans secured by those assets. Book value is often combined with other forms of valuation (such as the capitalization of excess earnings) to arrive at a more accurate valuation of the firm as a going concern. Startup ventures are often focused on growth and have little physical assets outside of investment capital. The growth nature of the firm means that these assets will be depleted to sustain its intended growth (e.g., continuing customer or user acquisition). Therefore, the measure of asset value in relationship to outstanding debt is a poor indication of a startups value. This calculation will only really be useful when applying for a line of credit or other debt arrangement, as lenders often look to unencumbered collateral to secure a loan to the business.
Intangibles and the Asset-Based Valuations
In addition to the failure of asset-based approaches to consider the entity value as a going concern, a salient deficiency of the asset-based approaches is the inability to accurately determine the value of intangible assets. This is particularly important is many startup ventures. These assets are difficult to value and often only have value within the business as a going concern. Examples of valuable intangibles include: on-going business relationships, industry reputation, brand recognition, human capital (knowledge or experience), and intellectual property (trade secrets, trademarks, patents, copyrights, etc.). All of these are intangible assets that serve to increase the value of the firm. In other instances a firm may have intangible assets that put the company at risk. For example, the firm may be the subject of intellectual property litigation.