Book Value Method

[Kathleen Reynolds]

#2374

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Determines the value of a corporation’s common stock by subtracting both liabilities and the par value of preferred stock from the value of the firm’s assets. It then arrives at a per share value by dividing the number of common shares outstanding into the adjusted book value.

Essentially, book value is assets minus liabilities. Book value is often a good starting point when calculating the value of a closely held corporation. This is especially true for the following businesses:

1. The business is predominately an asset holding company (e.g., an investment company).
2. The business is a real estate development business whose assets are the primary profit-making factor.
3. The business relies primarily on one person.
4. The business is currently (or close to) liquidating.
5. The business is very competitive, but only marginally profitable. In this case, examining past profits is an unreliable method of predicting future earnings.
6. The business or its assets are relatively new.
7. The business is likely to merge with another firm.
8. The business is burdened with large deficits.

Most businesses record assets at historical cost in their company’s books. For this reason, the firm’s book value must be adjusted to reflect the assets at fair market value instead of historical value.
Adjustments are recommended in the following cases:

1. When assets are recorded in the company’s books at cost rather than market value. For example, a closely held investment company usually records their marketable securities at cost. This creates a discrepancy between the book value and the actual worth of the business.
2. When assets are recorded in the company’s books at an excessive depreciation rate. For example, an operating company purchases machinery or equipment originally costing $1,000,000 but records a depreciated value of $300,000. The actual value of the equipment may be significantly more or less than either of these figures.
3. When a firm’s balance sheet fails to disclose potential lawsuits, unfavorable long-term leases, or other such items.
4. When assets with significant economic value have been completely written off.
5. When the business has carried franchises, goodwill, and other such assets on the books at a modest cost.
6. When the business has trouble collecting accounts receivable.
7. When the firm’s inventory contains goods that are either obsolete or not readily marketable.
8. When the business has insufficient working capital or liquidity position. When the firm has a significant number of long-term debts.
9. When the business’s retained earnings are high only because they have accumulated over a substantial period. This indicates a business with low current earnings and minimal potential for increasing its earnings.

NOTE: Be sure not to “double count” an asset when combining two or more methods.

In addition to the above adjustments, the value of any other class of stock with a priority as to dividends, voting rights, or preference to assets in the event of a sale or liquidation must be deducted from the value. For example, a common stock owner does not realize the value of the assets until preferred stock owners have been satisfied.

Book value should be used in conjunction with other valuation methods and not as the only method of valuing a closely held business.

Book value should also not be used when capital plays a minor role in profit making or where you are valuing the stock of a party who does not have the voting power to force limitations. In that case, book values have little relevance.

Entering Data

1. “Adjusted” Asset Value of Common Stock: Enter the adjusted asset value of the common stock.
2. Total Adjusted Liabilities: Enter the total amount of adjusted liabilities.
3. Par Value of Preferred Stock: Enter the par value of any preferred stock or other senior securities.
4. Number of Common Shares Outstanding: Enter the total number of common shares outstanding.

Results

The calculation results show the value per share of a corporation’s common stock. To calculate this value, the calculation subtracts both liabilities and the par value of preferred stock from the adjusted assets to arrive at the firm’s adjusted book value. It then divides the number of common shares outstanding into that adjusted book value to determine the value per share of the common stock.

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