Fair value and book value are two different methods of valuing a company. While both methods are widely used by investors to value companies for decision-making, both the methods are substantially different in the way they value the company.
Therefore, it is important to understand the differences between both methods.
The book value of a company also referred to as its net asset value, is the amount that would be attributable to the owners of the business after its liabilities are deducted from its assets (Net Assets = Total Assets – Total Liabilities).
The book value is the value of the business in its books, and that’s where it gets its name “book value” from.
In simple terms, the book value is the expected value of a business that its equity holders can expect to receive in case the business is liquidated after all the liabilities have been paid off using the company’s assets.
For example, a company ABC Co. having total assets of $100 million, and total liabilities of $70 million will have a net asset value of $30 million. This means, in case the company is liquidated its owners or equity holders can expect to receive $30 million.
Investors can easily derive any business’ book value from the balance sheet of the business.
The balance sheet of a business shows, at any given time, the company’s assets will always be equal to its shareholders’ equity and liabilities (Total Assets = Shareholders’ Equity + Total Liabilities).
This is basically the definition of book value rearranged. This means that to find out a business’s book value, investors need to simply find out the business’ shareholders’ equity value.
For example, Apple Inc. for the 2nd quarter of 2020, reported (values in millions) total assets of $320,400 (or $320 billion) and total liabilities of $241,975 (or $241 billion).
To calculate the book value of Apple Inc. its total liabilities have to be deducted from its total assets as mentioned above. This means the book value of Apple Inc. for the 2nd quarter of 2020 is $78,425 ($320,400 – $241,975 = $78,425 or $78 billion).
According to the above definition, $78 billion is what the equity holders at Apple Inc. are expected to receive if the company is liquidated at the end of the 2nd quarter.
It is important to know that the book value of a business can only be used for comparison within the industry the business operates in as different industries will have different trends.
Companies that rely heavily on human capital, such as football clubs or software companies, will have a lower book value than businesses like manufacturing businesses that have more fixed assets, including property, plant and equipment, financial instruments, and inventories.
The biggest drawback of relying on the book value of a company for decision-making is that the book value method relies on historical data. As with the example above, the book value of Apple Inc. could only be calculated using historical data.
This historical data may come at different intervals in at least every quarter or at most every year. This means that at the time of calculation of book value, the actual book value of the company may be different from the data that is being used.
In addition, the data used to calculate the book value of a company is subject to different “adjustments”.
Adjustments may come in many forms, for example, non-cash transactions such as depreciation, amortization, impairment, etc. the concepts of which may be hard to comprehend for investors.
For example, to understand the true impact of depreciation or amortization, investors have to look into several years of financial statements.
The fair value of a company, or its market value, is the value of the stock of the company in the stock market. It is calculated by multiplying the market price, of the company’s shares in the market, by its outstanding number of shares, at a given point in time. This is also known as market capitalization.
For example, a company ABC Co. having 5000 outstanding shares in the market with a current market price of $10 per share will have a fair value of $50,000.
Investors can also easily derive any company’s fair value by obtaining the relevant information about the number of outstanding shares and the current market price of those shares at any given time.
Unlike book value, investors don’t have to wait for historical data to be able to derive a company’s fair value, and the fair value of the company at any given date will be accurate.
Continuing with the example of Apple Inc., the outstanding number of shares of Apple Inc. at the end of the 2nd quarter was 4,443 million shares and the closing price of a share at that time was $ 247.74.
This means that the fair value of Apple Inc. at the close of the 2nd quarter was $1.09 trillion (4,443 million x $247.74). This indicates that the fair value of Apple Inc. at the close of the 2nd quarter was 14 times its book value.
The biggest drawback of the fair value method of valuation is that it is dictated by market factors and does not paint a true picture.
For example, a stock sold that is sold more during the day may have a higher share price in the market due to increased demand, while a stock that is sold less may have a lower share price in the market due to decreased demand.
The P/B Ratio
The P/B ratio (price-to-book ratio) is a ratio of the price per share of a company in the market and the book value per share of a company. In simpler terms, it is a ratio of the fair value of the company to its book value. The P/B ratio of a company can be higher than 1, lower than 1, or equal to 1.
When the P/B ratio of the company is higher than 1, it shows that the fair value of the company is higher than its book value. This denotes that the market trusts the company is worth much more than its book value.
This shows the market and the investors believe the company to have a great growth prospect and are willing to invest in the company in hope of a favorable return in the future.
When the P/B ratio of the company is lower than 1, it shows that the market has lost its trust in the company or that the company values its assets more than it is actually worth.
However, this fall may be temporary due to some rumors associated with the company in the market. Some investors take this as an opportunity to invest in companies with a P/B ratio lower than one with an expectation of future returns when the P/B ratio goes above 1.
When the P/B ratio of the company is equal to 1, this indicates that the fair value and the book value of the company are equal. This means the market has no reason to believe that the company is better or worse than what they have reported.
While both the book value of the fair value of the company shows different amounts, it is, ultimately, up to the investor to make the decision based on one of these.
However, this does not mean that the investor cannot use the information from both the methods together to make a decision.