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| Calculate Book Value of a Company |
There are several reasons why accounting statements are historical, but we will not contribute here to the debate over how accounting statements might better be prepared. We will simply review the information accounting statements provide, based on today's practice and note important implications of the procedures.
Market Versus Book Value of Assets
The current market value of an asset can be very different from its book value. Therefore, an asset probably can't be sold for its book value. If an asset can't be sold for its book value, it can not be bought for that value, either. So the cost to replace an asset that breaks down is probably different from its current book value as well. At the same time, four factors make a disparity between market and book values more or less likely, the time since the asset was acquired, inflation, the asset's liquidity and whether the asset is tangible or intangible.
Time Since Acquisition
As a rule, the more time that has passed since an asset was acquired, the greater the chance that the asset's current market value will differ from its book value. When an asset is acquired, it is recorded in the accounting statements at its cost. That cost is a market value, at least in some sense. Therefore, the initial book value is quite likely to be similar to the market value of the asset at the time it is acquired. Over time, however, the market value can diverge significantly from the book value. This is because changes in the book value (depreciation each period) are specified by GAAP rather than by economic considerations.
Inflation
Inflation during the time since the asset was acquired is a second important factor that can cause a significant difference between market value and book value. When prices change because of inflation, the market values of existing assets also change to reflect the difference in purchasing power. Such changes can be dramatic. For example, from 1990 until 1995, inflation caused the purchasing power of a dollar to change by a factor of 5. This means that what could be purchased for $1.00 in 1970 cost about $5.00 in 1995.Liquidity
An asset's liquidity is a third factor that affects the likelihood that the asset's current market value will differ from its book value. Less liquid assets have higher transaction costs when they are sold, so there's greater uncertainty about the net proceeds from a sale. As a consequence, if all else is equal, the current market values of less liquid assets can differ more from their book values.For example, compare a two year old pickup truck to a unique patented process for producing plastic bags. The pickup truck is a more liquid asset, because it is commonly available and there are many alternatives to that particular truck. In fact, there are established used truck markets for selling such assets with low transaction costs. Contrast this with the plastic bag production process. Such a production process may be worth much more than its book value if it is the leading production technology. It may be essentially worthless if another technology has made it obsolete. But in either case, it could be very costly and time consuming to find the buyer who will pay the most for the process, because there is not an established market for used plastic bag production processes.
Tangible Versus Intangible
A fourth factor that affects the likelihood of there being a significant difference between market and book values is whether the asset is tangible or intangible. The values of intangible assets are much more variable. As with our example of the plastic bag production process, intangible assets can be extremely valuable or essentially worthless. Valuation differences can also be caused by extreme differences in liquidity. Even long term assets such as plant and equipment are more likely to have established markets (real estate and used equipment) than are intangible assets such as patents or the design for a new product. Intangible assets tend to be unique. There are not active markets for selling them. Consequently, intangible assets tend to be extremely illiquid. Therefore, the current market value of an intangible asset is especially likely to differ from its book value.We noted earlier that placement on the balance sheet reflects the general remaining maturity of the assets. We should now point out that balance sheet placement also reflects the general likelihood that there will be a difference between the asset's book value and its market value. As you move down the list of assets, they are less liquid and have generally been held longer. Intangible assets are shown last.
Consider two types of assets that represent opposite extremes in liquidity, cash and a manufacturing plant. Cash is extremely liquid (actually, it is the very definition of liquidity), whereas it would probably require considerable effort to find a buyer for the plant. However, despite the fact that the market values of other current assets are generally less likely to differ from their book values, care is always in order when valuing a company. Accounts receivable can include bad debts. Inventory can be obsolete or can be shown at very low values because of a "last in first out" policy of accounting for inventory. Thus even the book values of current assets other than cash and equivalents can be poor approximations of market vale. Therefore, it is wise to look especially carefully at assets other than cash and equivalents when trying to value them.
Market Versus Book Value of Liabilities
As with assets, the current market value of a liability can differ from its book value. Generally, however, the potential divergence is smaller and the relationship between the market and book values is less complex.Remaining Maturity
The time until a liability must be paid off its remaining maturity is the main factor that affects the difference between the market and book values of a healthy company's liabilities. Liabilities have explicit contractual amount that must be paid at specific points in time. Failure to meet these contractual obligations creates the possibility of bankruptcy. Therefore, when a liability becomes due, the market value of the liability is essentially equal to its book value. In contrast, the market value of liabilities that do not have to be repaid for a long time reflects current economic conditions, as well as expectations about the future.Consider a loan for $10 million that is due to be paid off in four months. Because the remaining maturity is short, the cost of interest is relatively insignificant compared to the amount borrowed. Now consider a long term loan for $10 million at 6% interest per year that does not have to be repaid for another 25 years, except for yearly interest. If the borrowing rate today is 10%, the market value of this liability is smaller than its book value because its remaining maturity of 25 years provides the company with 25 more years over which to enjoy the low 6% interest cost on the existing loan.
Financial Distress
In our discussion of the impact of remaining maturity, we referred to a healthy company's liabilities. A second factor that affects the difference between the market and book values of liabilities is the company's financial health. The market values of a financially distressed company's liabilities are likely to be below their book values. This state of affairs reflects the fact that the distressed company may not be able to meet its obligations. Recall that corporate stockholders have limited liability. This increases the likelihood that the liability holders will not get paid. A distressed company's long term liabilities are especially likely to have a market value that is below book value because of the uncertainty about the company's long term viability. Thus financial distress can intensify the effect of remaining maturity on the market value of a company's liabilities.Total Value
The total value of a company is simply the sum of the market values of all its assets. Because the market values of the individual assets can be very different from their book values, the balance sheet amount Total Assets should never be taken as a reliable estimate of the current value of the company.Equity Value
The current book value of the company's equity is probably the least informative item on a balance sheet. Every factor that affects the difference between the market and book values of each individual item on the balance sheet affects the difference between the market and book values of the company's equity. This is because the difference between the market and book values of equity is the sum of the differences between the market and book values of all the other items on the balance sheet.
Stockholder's equity = Assets - Liabilities
This form makes it is easy to see the residual nature of the equity value. We have just said that the Assets amount is not the market value of the company's assets and that the Liabilities amount is not the market value of the company's liabilities. Therefore, it should be clear that the difference between the two is not miraculously going to become an accurate measure of market value, either!
If, instead of being book (historical) values, the Assets and Liabilities amounts were current market values, this equation would provide the true residual value of the stockholder's equity. In a GAAP balance sheet, however, the value of Stockholder's Equity is simply the result of applying the required rules to the historical cost of the assets and liabilities in essence, an amount that forces the balance sheet identity to hold. In a sense, then, the book value of stockholders equity is a "plug" figure that enforces the balance sheet identity.
As we will explain in detail later, stock prices observed in public market trading are a much more accurate basis for estimating the calculate to book ratio value of a company.
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