Book value of a company means the value of the entire business as per the financial statements. For instance, if you have financial statements for the year 2018-19, then from its balance sheet by deducting total liabilities out of total assets, you can get book value of the entire business. It’s also termed as owners’ equity or shareholders’ equity.
Total assets include all type of assets of the company such as accounts receivable, inventory, plant, machinery, furniture and fixture, computers, buildings and all other current assets and non-current assets shown in company’s balance sheet. Total liabilities includes all short and long-term obligations of the company.
To understand the difference between book value and market value of a company, we suggest you to first understand the concept with respect to a particular asset. Below is an example of machinery to understand the difference.
Suppose a company purchase a machinery worth Rs 1,00,000 with a life of 10 years. You as an accountant charged depreciation on this machinery at the rate of 10%, which comes to Rs 10,000 per year. At the end of the first year, this machine’s original cost will be reduced to Rs 90,000 (Rs 1,00,000-10,000).
Similarly, at the end of the 5th year cost of the machine would be Rs 50,000, i.e. Rs 1,00,000 minus Rs. 50,000 as depreciation (Rs 10,000 per year * 5). If at the end of 5th year, market price of the machine is Rs 70,000, then company can get Rs 20,000 as profit. In this case book value of the machine at the end of 5th year is Rs 50,000 and market value is Rs 70,000.
How to calculate book value and market value of a company
In simpler terms, book value of a particular asset is the original purchase cost minus depreciation charged over the years. Whereas, market value of that particular asset will be the current selling price in a open market.
Similarly, value of the company is reflected in its current market share price. For instance, if company XYZ’s closing share price is Rs 100 and it has 1,00,000 shares outstanding as on that date, market value of XYZ company = Rs 100 * 100000 = Rs 1,00,00,000. This means if there is one thing to recognize the market value of a company, then it’s the current market price of equity shares.
Market value of shareholders’ equity is calculated by multiplying the number of common shares outstanding by the market price per share.
If the company has total assets of Rs 1,00,00,000 and total liabilities of Rs 80,00,000, the company’s shareholders’ equity is Rs 20,00,000. This means, if the company is liquidated today, then after paying Rs 80,00,000 to outsiders from Rs 1,00,00,000, equity shareholders will get Rs 20,00,000.
Why to compare
Book value and market value of a company will always differ because the former is recorded at historical cost and the later depends on the demand and supply of market. Difference can also be due to the nature of company’s assets and liabilities and market conditions.
If the market price per share is greater than book price per share, then the stock is considered as overpriced. Investors would have assigned a higher price to the stock due to following reasons;
- Higher earning growth potential.
- Market price of the asset is higher than the historical price shown in the balance sheet.
Market price per share can also be less than book price per share for following reasons;
- Investors lost confidence on the management, company’s ability and its assets to generate future earnings and cash flows.
- Market value of the assets has come down.
- Investors have lost confidence in the company due to rumors or expectation of huge penalty or levy which can have impact on company’s bottom line.
If the market price per share is less than the book price per share, then the stock can be considered as trading at a discount. In this type of scenario, market is giving an opportunity to buy the stock at less than its net worth. If you think that market has under-priced a stock, then you can invest in it. However, we suggest you to do a thorough analysis as there is no guarantee that the price will rise in your favor.
As discussed above, market price will always fluctuate in comparison to book price. You can compare both by using price to book (P/B) ratio.
Both values gives meaningful insights to the company’s stock valuation. However, we suggest you to analyze the stock by taking help of all the financial tools available in fundamental analysis to get a complete picture of the financial conditions before investing. In this regards, price to earnings ratio, return on equity (ROE) and return on assets (ROA) can be helpful to assess company’s profitability and return potential.