Too embarrassed to ask: what is book value?

A popular way to value a company is to use the price/book ratio, which compares a company’s share price with its book value. But what is book value?

There are many ways to estimate the value of a company. One ratio that is popular with value investors in particular, is the price/book ratio, which compares a company’s share price with its book value.

So what is book value? Quite simply, it’s the total value of a company’s assets after subtracting all of its liabilities.You can find it in the balance sheet section of a company’s annual report. It’s also known as shareholders’ equity, or net asset value.

Assets come in two main types. Tangible assets include land, machinery, cash - anything you can “touch” (including cash in the bank, and other financial assets such as shares). Intangible assets include the value of a brand, or intellectual property rights – assets that you can’t touch, but which definitely have a value.

Intangible assets are harder to put a specific value on than tangible assets. It’s a lot easier to know what a fleet of vehicles is worth today than it is to put a precise value on a brand at any given point in time.Moreover, many of the costs that create intangible value (such as spending on research and development) never end up being recorded on the balance sheet as a result of accounting conventions.

Yet for many companies – tech stocks are an obvious example, but consumer goods companies are another – the value of the intangible assets may well be far greater than any physical assets they own. As a result, book value is arguably more useful for valuing companies with lots of tangible assets, such as housebuilders or banks.

If you divide the share price by the book value per share, this can give you an idea of whether the company is cheap or expensive.A price/book value of less than one means that, in theory, you can buy the company for less than its assets are worth.

In other words, if you had the means to buy the whole company, you could buy it, then sell off all of its assets immediately, and still make a profit. Of course, it may also imply that investors are sceptical as to the real value of the company’s assets.

To learn more about book value and its limitations, subscribe to MoneyWeek magazine.

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