When you are a company, there are different ways to assess your worth, and each is used differently to determine the company’s worth. For example, while shareholders are interested in a high market value, investors are keen on the book value of a company along with other factors to assess the company’s true value.
A company has numerous stakeholders, and each one of them uses the company’s financial information differently.
This blog discusses everything you need to know about book value. Since it also plays a significant role in business valuation, companies are advised to increase their book value, as it is crucial for business transactions in the future.
You can contact Wiley Financial Services anytime to help you with the business valuation in Utah.
A company’s financial statements are called its books. These books contain historical information about the company, for example, assets, liabilities, cash flows, and fund flows. These financial statements are not affected by the market but by routine business operations. Since all assets and liabilities are recorded at historical costs in these statements, it is called the book value of the balance sheet items.
The book value of a company is the difference between the historical costs of its assets and liabilities. For example, a machine was purchased for $10,000. It was recorded in the books for $10,000. But it will not always remain the same. The company’s earnings will accumulate due to the purchase, but the machine will depreciate over time.
Since all these changes are recorded in the company’s books, they represent the true and fair value of the company’s assets and liabilities.
The following formula calculates the book value of a company:
Book Value= All Assets- All Liabilities
You must be wondering if it is similar to the company’s net worth.
That’s correct. The book value represents, theoretically, the amount the company shareholders will receive in the event of liquidation.
But it isn’t that simple. For example, there are 100000 authorized shares issued by the company at $1 per share. Its net book value is calculated at $60000.
Now, if $60000 is divided among 100000 shareholders, the shareholders will receive $0.6 per share while they invested $1 per share.
The price-to-Book ratio refers to the ratio of a company’s share’s market price and its book value.
The formula of the Price-to-Book ratio is:
Price-to-Book Ratio= Market Value per Share/ Book value per Share
Market price represents the current market price of the company’s share.
Book value represents the share price recorded in the books.
Price-to-Book ratio signifies the price the shareholders are ready to pay in the open market for the company’s share against its book value. It helps you define whether the stock is undervalued or overvalued.
It can be understood with an example.
Suppose a company has authorized equity share capital of 100000 shares to be issued at $1 per share. Its paid-up capital is 100000 shares issued at $1 per share.
Here, the book value of the share is $1, which is recorded in the books. The shares are subscribed based on the company’s performance and shareholders’ confidence. Presently, the shares are traded in the market at $2. Anything received above the book value is recorded in the books as the share premium.
Here, the market value per share is $2.
Hence, price to book ratio is $2/$1 = 2.
It signifies the shareholders’ perception of the company.
A company that performs well has a good market reputation and is known to generate sufficient profits is sought by shareholders. They believe that if they invest in the company, it will pay them well in the future. These facts drive them to pay even more for a share.
So, if a share comes on the market and is subscribed by more people than it can be issued to, its prices rise due to high demand. It is called the overvaluation of shares.
On the contrary, if a company fails to convince the mass of its future, the demand lessens, and the market price of the share falls below its book value. It is called the undervaluation of shares.
The price-to-book ratio represents overvaluation and undervaluation.
The price-to-book ratio works effectively for listed companies, but it’s not the same for non-listed companies. You probably own most of the company shares if you have a private company. Thus, a comparative method is used. The market is studied for companies similar in size, net worth, market, future growth prospects, and other multiples.
Investors desire to ascertain the amount they must pay for the company, which is currently prevalent in the market for similar companies.
The price-to-Book ratio is often considered to ascertain whether a company’s book value is good. A price-to-book ratio of greater than 1 is considered good, but it is not a reliable measure.
A good book value is different for every industry and business based on its size and future prospects. A well-run business has a good book value, while a similar business lacking in sound decision-making and planning find it hard to compete and maintain a good book value.
Since book value only reflects the company’s net worth, which is based on past data, it does not indicate how the company will perform in the future. Deducting liabilities from assets only reflects how much is the company’s equity, but investors don’t purchase a business to sell it and make money. The aim is to generate revenue for the foreseeable future.
Thus, the book value of a business is used in business valuation, but the decision to buy a business does not solely rely on the book value of a company.
An accurate business valuation can change your future. The right approach by a team of experienced professionals can help you attract investors for your business and make informed decisions.
At Wiley Financial Services, we are dedicated to offering you the best business valuation services in California, Utah, and Arizona. With 20 years of experience under our belt, we boast of offering our business valuation services to many clients from various niches.
Contact us today for more information about our services!