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Book Value Definition
The book value of an asset is the value equivalent to the assets carrying value in the balance sheet. It is calculated through netting the asset against its accumulated depreciation. The book value is also calculated through the total assets less the intangible assets and liabilities to obtain the net asset value which is similar to the book value. The book value of an initial outlay of an investment can be the gross of expenses such as sale taxes and service charges.
A little More on What is Book Value
This is also called the net book value or net asset value. The book value has two main functions.
- It acts as the total value of a company’s assets that shareholders would get if the company were to be liquidated.
- It can be used to indicate whether a stock is under or overpriced when compared to the market value of a company.
In finance, the book value of an investment is described as the price paid in acquiring a security and debt investment. When a stock is being sold, the selling price less the book value gives rise to capital gains or losses on the investment.
The book value is derived from the accounting practice of recording the asset value in the books at the original cost. By accounting measurements, the book value of an asset may stay constant over time. However, the book value of a company can grow as a result of the accumulation of earnings generated through asset use.
Comparing a company’s book value with the market value of its shares serves as a valuation technique when deciding if the shares are priced moderately. This is because the book value of the company represents the shareholding wealth. However, a limitation to the accuracy of the book value serving as a proxy to the market worth of the shares can be realized if the valuation is not applied to assets whose market values may increase or decrease.
For example, a real estate property which is owned by a particular company may gain market value at times while its old machinery’s market value decreases as a result of advances in technology. In such a situation, the book value at the historical cost would change the company’s real value because of its fair market price.
The price-to-book ratio is used as a valuation multiple to compare the values between two similar companies in the same industry when they follow the same accounting method in asset valuation. This ratio, however, may not be a valid valuation basis in the comparison of the values of companies from different industries and which don’t use a similar method in valuing their assets. Because of this, a high ratio would not automatically mean a premium valuation, and a low ratio would not necessarily mean a discount valuation.
References for Book Value
Academic Research on Book Value
- Relative valuation roles of equity book value and net income as a function of financial health, Barth, M. E., Beaver, W. H., & Landsman, W. R. (1998). Journal of Accounting and Economics, 25(1), 1-34. This study attempts to test the forecast that the pricing multiples and incremental explanatory power of equity book value, increases as the financial health decreases.
- Equity valuation and negative earnings: The role of book value of equity, Collins, D. W., Pincus, M., & Xie, H. (1999). The Accounting Review, 74(1), 29-61. This paper explains the significant negative price-earnings relation using the simple earnings capitalization model for firms reporting losses.
- Biases and lags in book value and their effects on the ability of the book-to-market ratio to predict book return on equity, Beaver, W. H., & Ryan, S. G. (2000). Journal of accounting research, 38(1), 127-148. This paper distinguishes the two sources of variation in the book-to-market ratio where the ability of this ratio is implicated differently in the prediction of future book return on equity.
- Earnings, book values, and dividends in equity valuation, Ohlson, J. A. (1995). Contemporary accounting research, 11(2), 661-687. In this paper, a model of the market value of a firm is developed and analyzed as it relates to contemporaneous and future earnings, dividends, and book values.
- The usefulness of earnings and book value for equity valuation in emerging capital markets: evidence from listed companies in the People’s Republic of China, Bao, B. H., & Chow, L. (1999). Journal of International Financial Management & Accounting, 10(2), 85-104. This is an examination of the relevance of the relative value in the equity valuation of two sets of accounting information of listed companies in China which issued the B shares to investors on the Chinese stock exchanges.
- Combining earnings and book value in equity valuation, Penman, S. H. (1998). Contemporary Accounting Research, 15(3), 291-324. This article calculates the weights combining the valuations and show that these weights vary over the difference between the earnings and book value and that they do so systematically over some time.
- Empirical evidence of the effect of European accounting differences on the stock market valuation of earnings and book value, Arce, M., & Mora, A. (2002). European Accounting Review, 11(3), 573-599. This study attempts to investigate the value relevance of alternative accounting measures that are constructed under different accounting systems in Europe. It examines accounting practices differences through a relationship between earnings, book value and the stock market value of the firm.
- The effects of the Asian crisis, corporate governance and accounting system on the valuation of book value and earnings, Davis-Friday, P. Y., Eng, L. L., & Liu, C. S. (2006). The International Journal of Accounting, 41(1), 22-40. This is an examination of the value relevance of earnings and book value in four Asian countries during the period of the Asian financial crisis. The paper examines the impact of the economic environment on the value relevance of book value and earnings.
- Stock price, earnings, and book value in managerial performance measures, Dutta, S., & Reichelstein, S. (2005). The Accounting Review, 80(4), 1069-1100. This article creates a multiperiod principal-agent model where a manager must receive incentives to undertake investments and exert a costly effort personally.
- Regulation and the valuation relevance of book value and earnings: evidence from the United States, Nwaeze, E. T. (1998). Contemporary Accounting Research, 15(4), 547-573. This paper uses the benchmark results from a sample of manufacturing firms to show the degree of market-book alignment for firms which are regulated and competitive. These results do show a significant alignment of the market and book value of utilities.