In accounting and finance, it is important to understand the differences between book value vs fair value. Both concepts are used in the valuation of an asset, but they refer to different aspects of an asset’s value.
What Is Book Value?
It is an accounting measure of the net value of a company. It’s a metric used to calculate the valuation of a company based on its assets and liabilities.
If owners or executives sought to make a quick sale of their company and needed to sort out valuation, one method would be via book value. Going through their balance sheet, they would subtract liabilities from assets, providing a net asset amount.
Another term for book value is shareholders’ equity, which is a line item that can be found on the balance sheets of publicly traded companies’ quarterly and yearly filings with the Securities and Exchange Commission. Shareholders’ equity is usually found under the assets, liabilities, and equity section of the balance sheet.
How to Calculate Book Value (the book value formula)
The calculation of book value includes the following factors:
+ Original purchase price
+ Subsequent additional expenditures charged to the item
– Accumulated depreciation
– Impairment charges
= Book value
Example of Book Value
A company spends $100,000 to buy a machine and subsequently spends an additional $20,000 for additions that expand the production capacity of the machine. A total of $50,000 of accumulated depreciation has since been charged against the machine, as well as a $25,000 impairment charge. The book value of the machine therefore $45,000.
Why book value is useful
The primary advantage of using book value as a basis for a company’s valuation is that there’s little or no subjectivity involved in calculating the figure. When you buy an asset, its cost becomes the starting entry on the balance sheet for the value of that asset. Over time, the asset gets used up, and depreciation gradually reduces the balance-sheet value of the asset.
Although depreciation methods are generally simpler than the actual drop in an asset’s value over time, the approximation is close enough to give you a relatively accurate view of the current value of the asset in most cases.
Value investors like to refer to book value in searching for stocks trading at bargain prices. If a stock trades below book value, then investors typically see it as an opportunity to buy the company’s assets at less than they’re worth. The potential pitfall is that if the value of the assets on the balance sheet is artificially inflated, then a discount to book value is perfectly justified and doesn’t represent a bargain stock price.
What is Fair Value?
Fair value is a reasonable and unbiased estimate of the intrinsic value of an asset. Essentially, the fair value of an asset is based on several factors such as utility, related costs, and supply and demand considerations. Another common definition of fair value is the price that would be obtained for the sale of an asset or paid to transfer a liability in a transaction between the market participants at the measurement date.
Essentially, the estimation of an asset’s fair value is a generally complicated process. Determining the asset’s fair value is generally guided by accounting standards. IFRS and US GAAP provide guidance on how to measure the fair value of an asset.
Note that in accounting, the concept of fair value is not applied to all assets. Fair value is usually estimated for current assets that are held for resale such as marketable securities. Accounting using fair values is frequently exposed to potential accounting fraud due to the fact that companies can manipulate the fair value calculations.
Book value’s inescapable flaw is the fact that it doesn’t accurately account for intangible assets of value within a company, which includes items such as patents and intellectual property. What does this mean for investors? It means they need to be wise and observant, taking the type of company and the industry it operates in under consideration.
For example, consider a value investor who is looking at the stock of a company that designs and sells apps. Because it is a technology company, a major portion of the company’s value is rooted in the ideas for, and rights to create, the apps it markets.
The company could be trading much higher than its book value because the market’s valuation takes into account the company’s intangible assets, such as intellectual property. The stock, then, isn’t really overpriced – its book value is lower simply because it doesn’t accurately account for all the aspects of value that the company holds.