Defining Book Value of Equity
Book value of equity is an estimate of the minimum shareholders' equity of a company. Put another way, if a company were to close its doors, sell its assets and pay off its debts, the book value of equity is theoretically the amount that would remain to be divided up among the shareholders. Accountants tend to take a conservative approach to calculating the book value of equity. Typically, assets such as brand names and spending on research and development may be undervalued. Additionally, some assets are reported at depreciated values.
Computing Book Value Measures
Calculate book value of equity by subtracting a firm's total liabilities from its total assets to arrive at stockholders' equity. You can find these figures on the balance sheet. You can also use information on the balance sheet to compute the book value per common share. For this, subtract the book value of preferred stock from the total stockholders' equity. Divide the result by the number of common shares outstanding. Book value per share is a variation of book value of equity that is convenient for investors because you can compare it directly to the market price of the stock.
Relating Book Value to Price
Typically, the market value of a stock is greater than the book value of equity. This is partly because of conservative accounting practices, as well as the intangible value of certain assets such as trademarks. To illustrate, an investor will pay more than book value when a company is likely to introduce new and valuable products because the book value doesn't factor in investment in research. Another reason market value tends to exceed book value is that a successful company frequently earns a return that is relatively high compared to the book value of equity. In these cases, investors are naturally willing to pay more for the shares of such a company.
Book Value of Equity Limitations
Investors look to the book value of equity as a reference point to help them judge whether a stock is over- or undervalued by the market. However, book value tends to underestimate a firm's real worth. In addition, the book value of equity is a picture of the company at a single point of time. It tells the investor nothing about a company's growth rate, earnings or future prospects. For these reasons, book value of equity is most useful when used by investors along with other indicators of a company's financial condition.