Book value is the total value of the net assets of a company attributable to – or owned by – shareholders. It is calculated as the net asset value of a company, defined as the total tangible asset base (i.e., total assets minus intangible assets) minus total liabilities.
Book value provides useful information to investors by showing how much value might be distributed to stakeholders if the company were to undergo a liquidation scenario in the case of bankruptcy.
Some investors also use book value as the starting point of an investment strategy altogether. Namely, they will screen for “value” by only investing in companies trading below their book value on the open market. The ratio is referred to as price-to-book (P/B), or sometimes market-to-book.
Theoretically, if a business would be liquidated for more than its current market value, it represents a fundamentally undervalued company. Likewise, if a company is trading well in excess of its book value, it may be considered potentially overvalued or too risky of an investment to consider.
Book Value as an Accounting Concept
Book value refers to the accounting standard of recording an asset’s value at its historical cost on the balance sheet.
If, for example, a company bought a piece of Manhattan, New York real estate in 1900 for $1,000 and it has remained in its possession since, that $1,000 would remain constant on the balance sheet. Its modern-day value would not be reflected until it is sold to a different entity despite the value mismatch inherent in maintaining its value at historical cost.
Over its use, the company would be expected to create value by using the land to make a return in excess of what it paid for it. When this is the case taking its asset base on aggregate, the market value of a company will be in excess of the book value. When book value is below market value (P/B < 1), this generally indicates an inefficient use of assets, a concentrated assortment of older depreciated assets, or a potential mispricing of these assets (or the company they comprise) by the market.
Book Value’s Use for Day Traders
When considering using the P/B ratio to evaluate trading or investment opportunities, the ratio should not be taken as an automatic indication of “expensive” or “cheap”.
A company that has had real estate on its books for decades may seem expensive due to years of appreciation that hasn’t been accounted for in its book value. On the other hand, another company with old machinery on its balance sheet may seem cheap due to depreciation that hasn’t yet been recorded.
Some companies mark assets to market to reflect their true valuation over time while others mark them at historical cost, which causes this ratio to be unstandardized. Accordingly, a high P/B cannot automatically be taken as a high valuation while a low P/B should not be assumed to be a low valuation.
Therefore, one can use P/B ratios as a starting point for analysis, but cannot themselves provide a perfect reflection of “value” let alone offer insight into future market direction of the security being analyzed.