Book value of equity represents the fund that belongs to the equity shareholders and is available for the distribution to the shareholders and it is calculated as the net amount remaining after the deduction of all the liabilities of the company from its total assets.
What is Book Value of Equity?
The term “Book Value of Equity” refers to a firm’s or company’s common equity, which is the amount available that can be distributed among the shareholders, and it is equal to the amount of assets shareholders own outright after all the liabilities have been paid off.
Generally, the owner’s equity of a company is influenced by the industry in which it operates and how well it can manage its assets and liabilities. In fact, as a thumb rule, companies that are likely to perform well and generate higher profits are the ones that have a book value, which is lower than their market value.
We note from the above graph that Amazon’s book value has been increasing over the past 5 years and is currently at $43.549 billion.
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For eg:
Source: Book Value of Equity (wallstreetmojo.com)
Components
The book value of equity can be broken down into four major components, which are the owner’s contribution, Treasury shares, Retained earnings, and Other comprehensive income. Now, let us have a look at each of the components separately:
#1 – Owners Contribution (Common Stock & Additional Paid in Capital)
Common Stock is the equity capital at the par value of the shares, and the additional paid-in capital is the excess capital over an above the par value.
#2 – Treasury Shares
At times companies buy back some of the floating shares as part of corporate strategy. These repurchased shares are not canceled but rather held by the company as treasury sharesTreasury SharesTreasury Stock is a stock repurchased by the issuance Company from its current shareholders that remains non-retired. Moreover, it is not considered while calculating the Company’s Earnings Per Share or dividends. read more in their books.
#3 – Retained Earnings
It is the portion of the company profit not paid off to the shareholders of the company in the form of dividends. It is accumulated over a while if the company performs well and forms part of the shareholder’s equity.
#4 – Other Comprehensive Income
Other comprehensive income primarily includes net income as per the profit and loss statement coupled with the accumulated other comprehensive income of the previous year.
Book Value of Equity Formula
It is calculated by adding the owner’s capital contribution, treasury shares, retained earnings, and accumulated other incomes. Mathematically, it is represented as,
Examples of Book Value of Equity Calculations (with Excel Template)
Example #1
Let us take the example of a company named RSZ Ltd. As per the recent annual report published by the company, the following financial information is available to us. Do the calculation of book value of equity of the company based on the given information.
Based on the above formula, calculation of Book value of Equity of RSZ Ltd can be done as,
- = $5,000,000 + $200,000 + $3,000,000 + $700,000
- = $8,900,000
Therefore, the company’s common equity is $8,900,000 as on the balance sheet date.
Example #2
To understand the concept of the firm’s common equity, let us take a practical example of Apple Inc.’s annual report that was published on September 29, 2018. Do the calculation of book value of equity of Apple Inc. as on September 29, 2018. The following information was available:
Based on the above formula, calculation can be done as,
- = $40,201 Mn + $0 + $70,400 Mn + ($3,454 Mn)
- = $1,07,147 Mn
Therefore, Apple Inc.’s book value as on September 29, 2018, stood at $1,07,147 Mn.
Advantages
Now, let us have a look at the advantages of a Book Value:
- It helps in determining whether a stock is undervalued or over-valued by comparing it with the market price.
- It indicates the financial health of a company, i.e., a positive value is an indication of a healthy company. In contrast, a negative or declining value is a signal of weak financial health.
Disadvantages
Now, let us have a look at the disadvantages of a Book Value:
- Usually, the assets are carried at historical value, unless it is revalued, which is typically lower than the market value and eventually the understates the book value.
- Book value reports as part of the quarterly or annual filing. But the filings take time to publish, and as such, an investor comes to know about the book value of a company after a significant amount of time from the actual event.
- It fails to capture the impact of intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more because of its subjective nature of valuation.
Conclusion
Book value of equity is an important concept because it helps in the interpretation of the financial health of a company or firm as it is the fair value of the residual assets after all the liabilities are paid off. From the perspective of an analyst or investor, it is all the better if the balance sheet of the company is marked to market, i.e., it captures the most current market value of the assets and the liabilities.
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