Understanding Book ValueBook Value is one of the simplest and one of the most important measurements of a company's financial condition. It equals Owner's Equity, or the company's assets minus its liabilities as listed on the Balance Sheet.
Net Income increases the value of the business, or Owner's Equity, by increasing Retained Earnings. Posted earnings, however, do not always equate to an increase in the company's value (see table below). Investors and management place much attention on short-term earnings estimates, quarterly and annual earnings reports, and stock prices. Eagerly awaiting the next quarterly report, investors often buy and sell on short - term information. This expectation of short-term earnings places pressure on management to meet or beat those expectations, often sacrificing more important performance measures of long-term growth by focusing on short - term profits. Ultimately, however, it is the growing value of the company that determines the successes and failures of management and the real return on investment. In publicly traded companies, Book Value is measured as:
Book Value is what the company is worth if it were liquidated today. For publicly traded companies, it is compared to the company's Market Capitalization, or market value of all the company's stock outstanding. When the share price of a company's stock is low in comparison to the Book Value per Share, the stock is considered a bargain. Conversely, if the share price is high in relation to the company Book Value, the stock is considered expensive and possibly overpriced. Investors are either expecting an increase in future earnings, or are paying too much for the stock. Book Value is based on what the company paid for assets at the time of purchase, less any depreciation, as listed on the Balance Sheet. However, the fair market value of as asset, what an asset is currently worth on the market, may have no relation to what the value is on the Balance Sheet. For example, the company may have received a substantial discount on the asset, or the asset may be obsolete and worth much less than the listed value on the Balance Sheet. Nonetheless the value of a company as listed on the Balance Sheet reveals the long-term growth or loss in Owner's Equity, and the intrinsic value of a company, much better than short-term performance measures. For publicly traded companies, an increase in Owner's Equity is directly related to an increase in stock price.
This is a long-term correlation. In the short-term, stocks are subject to fickle buyers and sellers that give way to buying frenzies and selling panics. In the long-term, however, there exists a strong correlation between stock value and the value of a company. Why Short Term Profits Do Not Necessarily Increase a Company's Value: Accountants can manipulate short-term earnings in a variety of ways to paint a picture of consistent and growing earnings. Over the long-term, however, growth in Owner's Equity tells the true story of how a company has performed over the years. The below table shows three common examples of how earnings are manipulated: Short - Term Earnings and Accounting Gimmicks In the long-run, though losses are often manipulated in one form or another, the effect on assets and Owner's Equity is very real, and is reflected in the value of the company. The long-term growth in Book Value is a key indicator of a well managed, growing company and a healthy Balance Sheet.
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