The term “book value” can be used in a wide variety of economic contexts. Be it on the topic of stock trading or company valuations. In this post we look at the various aspects and show you the importance of book value for your entrepreneurship.
What is a book value?
In the corporate sense, the book value is the value that is the sum of all assets of the company (tangible assets, financial assets, etc.), whereby corresponding write- ups and depreciations must be taken into account and the company’s debts also flow into the valuation.
In stock trading, the book value of the company is often set in relation to the actual current share price. This results in the price-to-book value ratio, whereby we will go into more detail about its informative value.
Book value of stocks – definition
In the case of public companies , the book value of the company is compared with the share price. If the ratio shows that the shares are below the book value, this typically represents a buy signal, as an undervaluation of the share can be assumed. If the value exceeds one, the conclusion is that the company’s share is being traded dearly and that there is no corresponding book value behind it, which makes the company less attractive to new investors.
With all these considerations, however, other circumstances must also be taken into account that can justify a corresponding relationship between book value and share price, such as the development of the company’s reputation.
The tax book value – definition
From a tax point of view, it is important to know that all assets and liabilities are recorded at their book value on the balance sheet date. Subsequently, the assessment regulations must be observed. Specifically, this means that depreciation and write-ups must be taken into account.
This is to ensure that the balanced values are as realistic as possible. Since there are nonetheless deviations from reality, corresponding hidden reserves arise, which will be discussed in more detail below.
From a legal point of view, the valuation principles must be observed, which can be seen in Section 6 of the Income Tax Act, but also the calculations of write-ups and depreciations according to the Commercial Code and EStG. There is currently no legal definition for the book value.
The relationship between the share price and the book value
The ratio of the share price to the book value of the company is a popular measurement that is easy to calculate and is intended to provide a quick indication of the potential of the share.
Relevance in stock trading
In principle, investors are always on the lookout for undervalued stocks. These are stocks whose price is low in relation to the actual company value . For these stocks, it would be expected that the price would rise accordingly in order to really do justice to the company’s value.
Finding these low-valued stocks is like looking for a needle in a haystack – and once you find the right positions, you have to check what reasons are there for the supposedly low valuation.
Book value per share
Basically, the book value represents the sum of all assets, which can be tangible and intangible. For valuation purposes, the intangible assets are deducted and compared to the market value. In the simplest form of calculation, the book value per share results from the equity divided by the number of shares.
Shares below book value
If a share is listed below its book value, it is important to critically examine the reasons for this before making a purchase. For example, the company could be suffering from an image crisis or operating in an industry with a negative outlook. It is also conceivable that there are major risks or liabilities that have not yet been taken into account and therefore have no impact on the book value. It could also be that the actual company value has already decreased and this lower value is also reflected in the share price, although the book value is still higher.
Buying shares below book value is not always the right decision, because you need a holistic view of the company and its environment in order to really have a good basis for decision-making.
A simple example would be when a stock is trading well below its book value. Investors become aware of the security and check what the surprising price relationship could be. It turns out that the company was recently embroiled in a scandal. The book value is indeed available, but the company may face fines and the loss of image threatens to have a negative impact on profitability in the coming months and years.
Calculate book value – this is how the book value is determined
The book value can be calculated on various occasions, which we will now present individually.
Calculate the book value of stocks
For shares, the simplest calculation method is to divide the total equity of the shares by the number of shares. This is how the book value per share is determined.
Book value in company valuation
It gets a bit more cumbersome, but also not really complex, if you want to calculate the book value in the course of a company valuation or the book value of the balance sheet .
You start from the acquisition or production costs, add the write-ups and subtract the depreciation.
It should be noted that the depreciation is usually calculated linearly, which does not necessarily have to correspond to reality. Therefore, the fair value and book value are sometimes far apart, unless the depreciation is actually correctly applied.
For the company valuation, the book value represents the hard core of the company, so to speak. This value is reduced by liabilities. However, this alone does not result in an assessment, it is only a first, rough insight. Alternatively, consider intrinsic value – the amount the company would make if it sold all of its assets.
Calculate the book value of a car or property
With vehicles in particular, it is known that the loss in value is particularly high in the first year. The depreciation would be linear, which is not true. In order to determine the real value of the car, the current value should be assumed and not the book value, which will initially be too high after the car has been bought. The opposite is true for cars that have been used for a long time.
As a result of the depreciation, these de facto no longer have a book value – but could probably still be sold for little money, i.e. above book value. If that is the case, a hidden reserve has developed here, which is now being realized, whereby this profit must of course also be taxed.
The situation is just as interesting for real estate. The production costs, for example when building a house, are easy to determine. But if a region is upgraded over the years, the real value of the building also increases. The book value is therefore actually set too low – the sales proceeds would be higher, there is a hidden reserve .
Book profit and book loss
The difference between the book value and the actual value results in book profits and book losses when an asset is sold. Every book profit is taxable. The determination of the book profit or book loss is very easy.
Take, for example, a car that was bought for 30,000 euros.
The useful life is five years, so the annual depreciation is 6,000 euros. The car is sold for 20,000 euros after just one year. The sale takes place below the book value, there is a book loss.
The role of book value in business valuation
In the company evaluation, an attempt is made to determine the most transparent and correct picture possible of the company’s actual value. It quickly becomes apparent that the book values do not always have to be suitable for this calculation. In reality, different company values can be significantly different from their book values. Be it vehicles whose value is already lower than recorded or properties whose value has increased over the years. Trademarks can also be under- or over-valued accordingly.
From the point of view of investors, the most attractive companies are those that are in a good environment, deliver positive results and still have a good relationship between book value and share price. The book value is therefore an important aspect for company valuation, but at the same time it must never be viewed as a single value in isolation, because in this case investors could quickly get on the wrong track.
Definition of book value
As we have already seen using the example of cars and real estate, the book value does not always correspond to the current value of a good. In reality, the fair value can be significantly higher, but also lower than the book value suggests.
The difference between book value and fair value
The book value is a calculable, static value that is determined on the basis of fixed factors. The fair value, on the other hand, reflects the real, current value retention. It also shows how the value of a good has actually developed and where it is in real terms today, on the free market.
Fair value calculation
The fair value can thus be calculated by taking the acquisition or production costs into account, taking depreciation and write-ups into account and then carrying out a corresponding value correction which is intended to show the actual market situation.
The terms of market value and market value are usually used synonymously.
Book value and hidden reserves
We have now seen that the book value of various assets can be significantly lower than the real market value. Most companies are fully aware of this fact. It can be material things that have increased in value, such as real estate, or immaterial objects that have increased in value, such as a brand.
However, if these goods are not sold, there is no book profit. Instead, unrealized book profits are referred to as hidden reserves that exist in the company. If the company had a need for capital , for example, an apartment with a low book value in terms of fixed assets , although the market situation has changed, could sell this property at a high price. Through this process, the value previously viewed as a hidden reserve would be realized, resulting in a book profit.
Book values and the close link to depreciation
The depreciation is the decisive factor in the calculation and has a corresponding influence on the result when the book value is determined. The amount of depreciation can practically not be influenced by the specification of the useful life.
If the fair value is higher than the book value, the asset should be left on the balance sheet unless it has to be sold, as otherwise the corresponding book profit would be incurred, which entails a corresponding tax burden.
Book value – conclusion
Short for BV by abbreviationfinder, the book value is an exciting value in many ways, but its informative value is unfortunately always only relative. Depending on the context in which the book value is dealt with, other parameters must also be used. Be it other external circumstances in the company valuation or other factors that should be considered before buying a stock.
The actual fair value can correspond to the book value, but it can also lie in completely different spheres. In this way, companies create hidden reserves that are uncovered when the item is sold and thus become book profits that must be taxed.