When it comes to making investment decisions, it can be hard to figure out what to focus on. There is simply too much information floating around. Each piece of data focuses on various aspects of company performance. It can be confusing to determine which values most accurately represent the returns potential of a company. Among such vital information is the book value of equity.
Most experienced investors focus on past data to make investment decisions. Consistent past patterns can show the future performance of a company. Coupled with real-time statistics, they can lead to well-informed investment decisions. Determining the book value of a company is one of many practical investment tools.
What is the book value of equity?
A company's book value of equity indicates the total value of a company's assets. As a theoretical value, it demonstrates how much you will receive if the company liquidates. It is used to determine the value of a stock and can be an essential investment tool.
The book value is based on the assets owned by a company after excluding all the liabilities. It is determined by selling all company assets to pay off liabilities after using them. Also known as shareholder's equity, it is the amount shareholders would receive if the company closed. The value of a company's equity is influenced by several factors. These include the company's market and its assets and liabilities.
What are the major components of the book value of equity?
To understand how the book value of equity works, you must understand its various elements. It has several major components: these are all the factors that go into determining the book value.
Total assets and liabilities
Book value is based on a company's total assets and liabilities. These are indicated on the company's balance sheet, which also shows the net value. Total assets equal the sum of the book value of all the assets owned by a company. You can calculate asset book value by subtracting depreciation from its original value.
A company's total liabilities are the accumulation of all the debt it owes. These are the sum of the current and non-current liabilities. In other words, they include all short-term and long-term debts. Equity is calculated by subtracting total liabilities from total assets.
A company's retained earnings are the amount left over after dividends have been paid out. Such earnings tend to accumulate over time to form part of equity book value. They do not appear as assets in the balance sheet but can be used to invest in assets.
Therefore, most companies with high retained earnings are in a position to buy a large number of assets. They may also use the earnings to increase shareholder dividend payments.
The cumulated profit indicated by retained earnings shows a company's financial health. It indicates the net income a company has saved over time, opening up opportunities to reinvest. It shows good financial planning by the company. You may prefer investing in a company with high retained earnings.
On average, retained earnings can make up close to half of the book value.
Treasury shares are stocks that issuing companies repurchase on the stock market. Rather than canceling, such stock is recorded as treasury stock in the balance sheet. The result is fewer shares floating in the market.
Companies obtain treasury shares for multiple reasons. It can be to resell the shares at a later date or value or to prevent a hostile takeover of the company. Treasury stock can also help prevent the undervaluation of company shares. By reducing outstanding shares, current shareholder interest also increases.
Contributed surplus refers to the sale of shares at a price above the par value. Par value is the share value of a single share set in the company's charter. It is also indicated on the stock certificate issued with the stock purchase.
This additional paid-in capital is recorded on the balance sheet. It is used as an indication of a company's future growth and performance. This is because it shows investors were willing to pay over the par value. The surplus, therefore, indicates interest in the stock.
Share capital is raised from the sale of the firm's common equity. This is traded at the par value. Along with common stock, it also includes preferred stock, which comes with a fixed dividend. Naturally, share capital is essential to the value of a company.
In addition to raising investment capital, it is needed for creditors' claims. The market value for total issued common stock and preferred stock makes up market capitalization.
Other comprehensive income
Other comprehensive income (OCI) includes
These are not shown on the income statement or included in net income calculations. Specifically, it includes income or losses that have not yet been realized. Therefore, their actual value cannot be determined at the time. OCI is recorded as unrealized income on the income statement. This categorization was set out in the Statement of Financial Accounting Standards No. 220.
Accumulated other comprehensive income
Accumulated other comprehensive income differs slightly from OCI. It shows any unrealized losses or gains changes and is recorded on the balance sheet. A good example would be an investment that has not yet matured, such as a bond portfolio. It would be recorded as OCI, and any changes in the portfolio would be recorded in the balance sheet.
How to calculate the book value of equity?
You can determine book value by equity calculation based on its financial statements. To that effect, the book equity formula is simple:
Book value of equity= Total assets – Total liabilities
Example use of the book value of equity formula
An example of the use of this formula assumes the value of Company A's assets and liabilities:
Total assets: $200 million
Total liabilities: $130 million
If Company A were to liquidate, it would sell off its assets at fair value to pay off its liabilities. Consequently,
Book value of equity (BVE): 200 m – 130 m = $70 million
The book value of equity indicates the net worth of Company A.
Assets and liabilities in book value
A company's financial assets and liabilities are reported on the balance sheet. The book value of equity on the balance sheet can also be seen under the shareholder's equity section. Total assets for a company can include:
- Accounts receivable
- Short-term investments
- Intangible assets
Total liabilities can include:
- Debt, loans, and mortgages
- Accounts payable
- Deferred payments
- Accrued expenses
Why do I need to know the book value of equity?
The book value of equity is an essential indicator of a company's financial health. While this value is only provided for a specific point in time, it can be used for comparative analysis. Current equity can be compared to previous book equity to map company performance and invest in common stock.
Along with a company's financial strength, it also shows the efficiency of operation. It lends a better understanding of what you will be getting with an investment in that company. A good book value of total shareholder's equity shows a company that is performing well and making profits. Similarly, weak equity indicates financial trouble.
A major factor in investment decisions is whether the amount you invest is worth the returns. Shareholder's equity helps you determine the valuation of the stock. This can be used to decide when to invest and when to sell off common stock. As an indicator of earnings after liquidation, it shows what you can expect to receive.
What limitations should I know about?
The book equity formula is effective and informative for many investment decisions. However, it is also limited in a number of ways. One of these is the limited reports of equity value. Since it is reported on the balance sheet, the book value of equity is only available annually or quarterly. This means investors looking to analyze equity value will have to wait for the report.
By the time reports are published, many changes may have already occurred. These will not be reflected in the company's statements. Any decisions investors make will be based on outdated information. This can lead to poor financial decisions as a result.
Calculations involved in the book value of equity can become complicated and inconsistent. For example, assessing the effects of depreciation on company assets can be confusing. The value of depreciation may vary widely depending on the technique used by the company. Additionally, you may need a lot of old data to make sense of fluctuations like depreciation.
Furthermore, some assets may gain historical value. You need to configure this in your calculations to reach an accurate figure.
Additionally, assets involved in determining equity value also include intangible assets. The question of assigning them a financial value can create discrepancies. For example, assets like intellectual property may play a significant role in a company's profits. If they are undervalued, they can lead to inaccurate equity values.
Understanding the book value of equity as an investment tool
A book value ratio that is lower than the current market price indicates a stock that is overvalued. This means it is selling at a price much greater than its value. Conversely, a book value higher than the market price indicates an undervalued stock. The stock is selling at a price lower than its value.
As an investment, the undervalued stock is a preferred choice. Based on the book value of equity indicates profitable companies are expected to succeed financially. It also presents long-term growth opportunities. At the same time, such stock is much cheaper to buy, especially in terms of the value it provides.
You can determine what stock may offer better returns at a lower market price than the market value. Undervalued stock from well-established companies offers can generate higher profits.
In the case of either stock value, market prices tend to return to their original value. For undervalued stock, this offers an increase in price. On the other hand, for overvalued stock, this means a drop in prices. Such stock is trading at a price not justified by its value. Rather than an investment, it is safer to sell overvalued stock.
Book value vs. equity: Are they the same thing?
To put simply, equity is the shares issued by a company. They are traded on the stock exchange, where they are bought and sold. In effect, equity represents the market value of shares owned by shareholders. The equity value is determined by the price of a share multiplied by the shares outstanding.
Book value shows a company's future financial status based on its current performance. The equity value provides a current picture of how a company is performing. The book value of equity indicates what shareholders would make if the company were to liquidate.