Table of Contents
- 1 Book Value of Equity Meaning
- 2 Formula
- 3 Book Value of Equity Calculation
- 4 Book Value per Share
- 5 Limitations of Book Value of Equity
- 6 Price to Book Value Ratio
Book Value of Equity Meaning
The book value of equity more widely known as shareholder’s equity is the amount remaining after all the assets of a company are sold and all the liabilities are paid off. In other words, as suggested by the term itself, it is that value of asset which reflects in the balance sheet of a company or books of a company.
From this understanding we can now derive the formula of the book value of equity as follows:
Book Value of Equity = Total Assets – Total Liabilities
Book Value of Equity Calculation
Following are the important components of the formula of Book Value. Let’s understand each component for precise calculations.
Capital Contributed by Owners
This is the amount contributed to the company by its owners. This component is commonly known as common stockholder’s equity or common stock of the company.
Preferred shares can be classified as equity or financial liabilities. This classification is based on their characteristics. For example, perpetual, non-redeemable preferred shares are classified as equity. On the other hand, preferred shares with the mandatory redemption of a fixed amount at a fixed future date are considered to be a financial liability.
These are the shares that have been repurchased by the company and the company holds them as treasury shares rather than canceling.
This is the cumulative amount of earnings that have not been paid to the owners of the company as dividends.
Accumulated Other Incomes
Other comprehensive income includes:
- Net income (As per income statement)
- Other comprehensive income (As reflected in accumulated other comprehensive income)
Noncontrolling Interest (Minority Interest)
This is the equity interests of minority shareholders in the subsidiary companies that are held by the parent. These subsidiary companies are not wholly owned by the parent company.
For better understanding, let’s look at an example:
Following is the balance sheet of Apple Inc. as on 31/09/2017
In the above financial statement, book value of equity is US$ 134.05 billion (as highlighted). This amount includes common stock, retained earnings and other equity. If we apply it to the formula –
Book Value of Equity = Total Assets – Total Liabilities
Apple Inc. (Book Value) = US$ 375.32 billion – US$ 241.27 billion = US$ 134.05 billion
For the purpose of analysis, the book value of equity is further divided by a total number of shares to make book value per share. Book value per share represents equity of the firm on per share basis. This means if the company dissolves, the shareholders will receive an amount per share as per book value per share.
The formula for book value per share = book value of equity / total number of outstanding shares
Taking above example of Apple Inc., we can calculate the book value per share as follows:
Book Value per Share = US$ 134.05 billion/ 5.126 billion shares = US$ 26.15
Therefore we can say if the Apple Inc. dissolves on 31/09/2017, shareholders will get US$ 26.15 per share.
Limitations of Book Value of Equity
There are some limitations of using book value of equity as a metric for measuring the performance of a company. We are listing a few of them below:
Depreciated Value vs. Current Market Price of Assets
Depreciation is an accounting phenomenon, i.e. there is no accurate measure to calculate the rate of depreciation. The book value of asset completely depends on how aggressively a company depreciates its assets. This means the sale price of an asset may or may not be equal to its depreciated book value. If a company has depreciated its asset very aggressively, chances are that the sales price is higher than book value. This means the reported book value of equity is lower than actual book value & vice versa.
Subjective Valuation of Intangible Assets
Intangible assets include assets like goodwill, patent, trademarks and the likes. The issue with the value of intangible assets is that it is very subjective. The book value is only a perception of the price of intangible assets. The market perception of the price of intangible assets may be very different from book value. If the market perceives the price of an intangible asset lower than its book value, this means the reported book value of equity is higher than actual book value & vice versa.
Suppose a company has bought a piece of land in the year 2012. As of today the value of land has appreciated by 40%. But the book value of this land will reflect the purchase price of the land. This will reduce the reported book value of equity. Unless the company has updated its balance sheet with fair values of assets and liabilities, the book value of equity will not reflect the real picture.
Price to Book Value Ratio
Price to book value of P/B ratio is a relationship between the market price of a company’s share and its book value.
The formula of P/B ratio is:
P/B ratio = Market Price per Share / Book Value per Share
Let us again go back to our example of Apple Inc. & try to interpret its P/B ratio
P/B ratio of Apple Inc. as on 31/09/2017 = US$ 154.12 market price per share/ US$ 26.15 book value per share. = 5.89 i.e. 6 approx.
From the P/B ratio of Apple Inc., we can interpret that Apple Inc stock is selling at 6 times the book value.
On the final notes, we can conclude that to interpret anything from the book value of equity, it is important that the book value reflects the fair value of its assets and liabilities. As an investor or analyst we must be sure that the balance sheet of the company that we are analyzing is marked to market, i.e. reflects the most recent market price of assets and liabilities.
- Analysis of Financial Statements, 3rd edition – Gerald I. White, Ashwinpuri C. Sondhi, Dov Fried
- Financial Reporting & Analysis – CFA level-1 2012, CFA Institute USA