Book value is a term that describes the basic net worth of a company. It's the total of its assets minus its liabilities.
A company's book value is one of the key ways an investor can evaluate the financial state of the company and its potential as an investment. Every investor should understand what book value is and how to evaluate it.
Definition and Examples of Book Value
The book value of a company is simply its assets minus its liabilities. This means the total value of all assets except for intangible assets with no immediate cash value, such as goodwill. Liabilities include all current and long-term monies owed.
Book Value = Assets - Liabilities
In other words, if you wanted to close the doors of the business, how much money would be left after you sold off all the assets and settled all the outstanding obligations? That's the company's book value.
For example, say a company has a total of $2 million in assets and $1 million in outstanding liabilities. Its book value would be $1 million.
- Alternate terms: Net worth, shareholders' equity
How To Use Book Value in Investing
Book value on its own doesn't give you a lot of information about the real value and potential return of a company. For instance, just because one company has a net worth of $1 million and a second has a net worth of $2 million, that doesn't mean the second is automatically the better investing choice. That's why investors who use it often look book value it in relationship to other metrics in order to compare different stocks.
One way to compare companies is to convert to book value per share, which is simply the book value divided by the number of outstanding shares. Continuing our example from above:
- The first company has a book value of $1 million and has 100,000 shares outstanding. Its book value per share is $10.
- The second company is worth $2 million and has 10,000 shares outstanding. Its book value per share is $200.
Another common metric investors use is to compare price-to-book ratio across companies. This ratio compares a company's price per share to its book value per share. Continuing our example:
- The first company has a book value per share of $10 and a market price of $50 per share. Its price-to-book ratio is 5.0. Investors are likely to see this as a stock that has been overvalued.
- The second company has a book value per share of $200 and has a market price of $100 per share, Its price-to-book ratio is 0.5. Investors are likely to see this as a stock that has been undervalued.
As you can see, the second company looked like the more attractive investment at first, but some deeper evaluation has raised some red flags.
Savvy investors will always be careful to evaluate a stock from multiple angles instead of purchasing based on only one value indicator.
The Limits of Book Value
Another factor in evaluating book value is the fact that it doesn't factor in intangible assets. These include things such as patents, copyrights, and trademarks. While these assets aren't tangibly valued on a company's books, they offer significant value over time.
For this reason, investors should always look at other valuation metrics that deal with factors outside book value.
A company that is a viable, growing business will always be worth more than its book value because of its ability to generate earnings and growth.
Other Important Values for Investors
You won't want to jump in with both feet on an investment until you understand many other components of a stock's value. Here are a few other common terms you might want to look into and make sure you understand:
- Earnings per share (EPS): This is the percentage of a company's profit that is dedicated to each share of stock.
- Price-to-earnings ratio (P/E): This measures the current price of a share against per-share earnings.
- Projected earnings growth (PEG): This evaluates the price-to-earnings ratio in comparison to the growth ratio.
- Price-to-sales ratio (P/S): A company's market cap is divided by its most recent yearly revenue. P/S can also be determined by dividing the price of a stock per share by per-share revenue.
- Dividend payout ratio: This compares the number of dividends paid to stockholders vs. the company's total net income.
- Dividend yield: This is a percentage of the current price of a share.
- Return on equity (ROE): ROE evaluates a company's profitability in relation to the book value of each shareholder's equity.
- Book value is a measure of a company's net worth—its assets minus its liabilities.
- Investors can use it to assess a company's value in relation to its total available shares and price per share.
- It's important to evaluate book value along with other metrics before determining whether a stock is a good choice for investment.