12. Book Value

12.1. What is Book Value?

An asset’s book value is equal to its carrying value on the balance sheet, and companies calculate it netting the asset against its accumulated depreciation. Book value is also the net asset value of a company calculated as total assets minus intangible assets (patents, goodwill) and liabilities. For the initial outlay of an investment, book value may be net or gross of expenses such as trading costs, sales taxes, service charges and so on.

12.2. Breaking Down Book Value

Book value is also known as “net book value” and, in the U.K., “net asset value.”

As the accounting value of a firm, book value has two main uses:

1. It serves as the total value of the company’s assets that shareholders would theoretically receive if a company were liquidated.
2. When compared to the company’s market value, book value can indicate whether a stock is under- or overpriced.

In personal finance, the book value of an investment is the price paid for a security or debt investment. When a company sells stock, the selling price minus the book value is the capital gain or loss from the investment.

For more information, check out Digging Into Book Value.

12.3. Historical Cost

The term book value derives from the accounting practice of recording asset value at the original historical cost in the books. While the book value of an asset may stay the same over time by accounting measurements, the book value of a company collectively can grow from the accumulation of earnings generated through asset use. Since a company’s book value represents the shareholding worth, comparing book value with market value of the shares can serve as an effective valuation technique when trying to decide whether shares are fairly priced.

12.4. Mark-to-Market Valuation

There are limitations to how accurately book value can be a proxy to the shares’ market worth when mark-to-market valuation is not applied to assets that may experience increases or decreases of their market values. For example, real estate owned by a company may gain in market value at times, while its old machinery can lose value in the market because of technological advancements. In these instances, book value at the historical cost would distort an asset or a company’s true value, given its fair market price.

12.5. Price-to-Book Ratio

Price-to-book (P/B) ratio as a valuation multiple is useful for value comparison between similar companies within the same industry when they follow a uniform accounting method for asset valuation. The ratio may not serve as a valid valuation basis when comparing companies from different sectors and industries whereby some companies may record their assets at historical costs and others mark their assets to market. As a result, a high P/B ratio would not necessarily be a premium valuation, and conversely, a low P/B ratio would not automatically be a discount valuation.

12.6. Understanding Net Worth

Net worth (assets minus liabilities) gauges financial health. An asset is anything that is owned and has monetary value while liabilities are obligations that deplete resources. Assets can be liquid when they are, or can be easily turned into, cash (like a checking account). They are non-liquid when it could take time to turn into cash (like a home). Liabilities are obligations that have to paid off (like a car loan).

Net worth provides a snapshot of an entity’s current financial position. Positive and increasing net worth indicates good financial health, while a decrease would be cause for concern as it might be indicative of a decrease in assets relative to liabilities.

The best way to improve one’s net worth, whether it be an individual or corporation, is to either reduce liabilities while assets either stay constant or rise, or increase assets while liabilities either stay constant or fall.

Key Takeaways

Net worth is a quantitative concept that measures the value of an entity and can be applicable to individuals, corporations, sectors and even countries. Net worth is the difference between assets and liabilities and provides a snapshot of an entity’s current financial position. In business, net worth is also known as book value or shareholders’ equity. In fact, the balance sheet is also known as a net worth statement. People with a substantial net worth are known as high net worth individuals (HNWI).

12.7. Net Worth in Business

In the business context, net worth is also known as book value or shareholders’ equity. In fact, the balance sheet is also known as a net worth statement. The value of a company’s equity equals the difference between the value of total assets and total liabilities. Note that the values on a company’s balance sheet highlight historical costs or book values, not current market values.

Lending institutions scrutinize a business’ net worth to determine if it is financially healthy. If total liabilities exceed total assets, which is negative net worth, a creditor may not be too confident in a company’s ability to repay its loans.

A company that is consistently profitable will have a rising net worth or book value, as long as these earnings are not fully distributed to shareholders as dividends but are retained in the business. For public companies, rising book values over time may be rewarded by an increase in the value of stocks trading in the markets.

12.8. Net Worth in Personal Finance

An individual’s net worth is simply the value that is left after subtracting liabilities from assets. Examples of liabilities (debt) include mortgages, credit card balances, student loans, car loans, etc. An individual’s assets include checking and savings account balances, value of securities such as stocks or bonds, home value, market value of an automobile, etc. In other words, whatever is left after selling all assets and paying off personal debt is the net worth. Note that the value of personal net worth includes the current market value of assets and the current debt costs.

Consider a couple with the following assets - primary residence valued at $250,000, an investment portfolio with a market value of $100,000, and automobiles and other assets valued at $25,000. Liabilities are primarily an outstanding mortgage balance of $100,000 and a car loan of $10,000.

The couple’s net worth would, therefore, be calculated as [$250,000 + $100,000 + $25,000] - [$100,000 + $10,000] = $265,000

Assume that five years later, the couple’s financial position is as follows - residence value $225,000, investment portfolio $120,000, savings $20,000, automobile and other assets $15,000; mortgage loan balance $80,000, car loan $0 (paid off). The net worth five years later would be [$225,000 + $120,000 + $20,000 + $15,000] - $80,000 = $300,000.

In other words, the couple’s net worth has gone up by $35,000 despite the decrease in the value of their residence and car. The increase in net worth is due to the fact that the decline in residence value was more than offset by increases in other assets (such as the investment portfolio and savings) as well as the decrease in liabilities.

An individual can have a negative net worth if his debt is more than the value of his assets. For example, if the sum of an individual’s credit card bills, utility bills, outstanding mortgage payments, auto loan bills, and student loans is higher than the total value of his cash and investments, his net worth will be negative. In this case, the individual may file for Chapter 7 bankruptcy protection to eliminate some of the debt and to prevent creditors from trying to collect on the debt. However, some liabilities such as child support, alimony, and taxes, cannot be discharged. In addition, a bankruptcy will stay on an individual’s credit report for many years.

People with a substantial net worth are known as high net worth individuals (HNWI), and form the prime market for wealth managers and investment counselors. Investors with a net worth (excluding their primary residence) of at least $1 million - either alone or together with their spouse - are considered as “accredited investors” by the Securities and Exchange Commission (SEC), for the purpose of investing in unregistered securities offerings.

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