Book Value vs Fair Value

What Is Book Value?

Book value is a term for the value of an asset that appears on the company’s balance sheet. It is calculated by deducting the accumulated depreciation and other impairment charges from the asset’s historical price.

As the value is calculated after deducting the depreciation, the value of the asset can also be defined as the net asset value of the company, which in accounting terms is calculated as the difference between the firm’s total assets and intangible assets such as patents, copyrights, and goodwill, and liabilities.

For example, if a firm purchased machinery worth $100,000, depreciation on the asset is calculated straight-line for five years. So, the book value of the asset after accounting for depreciation for two years ($40,000) would be $60,000.

Calculation:

Year 1 = $100,000 - $20,000 = $80,000

Year 2 = $80,000 - $20,000 = $60,000

As the book value of an asset is based on its historical cost, it generally tends to be lower than the asset’s market value. Therefore, the BV of an asset is used to assess if the asset is over/underpriced by comparing the variance of value between the BV and the market value.

The BV of assets is not very important because of its historical perspective to evaluate assets and service or product-based industries. But, if we look at heavy capital and asset-based companies and industries, it might have increased relevance. 

In the case of shares, BV per share is calculated by dividing shareholder’s equity less preferred stock by the number of equity shares issued by firms in the market. Such valuations, along with the price-to-book ratio, are used by employees of the firm for fundamental analysis.

BV per share = (shareholders’ equity - preferred stock) / no. of equity shares issued

Advantages of using Book Value Accounting

The advantages of using book value accounting by accountants are listed as follows: 

• The most significant advantage of using book value accounting for company valuation is that the book valuation method accounts for little or no subjectivity in calculating the company’s value, reflecting an objective value. As the assets get used up and depreciate over the years, the value of the asset being reflected on the balance sheet reduces from the price paid to acquire the asset.
• Although depreciation and impairment costs that are reduced from the asset's cost base are just approximations, it gives a rough estimate and a reasonably accurate view of the asset's actual value.
• Value investors (investors who buy stocks that are being traded at a discount compared to their intrinsic value) tend to prefer the book value of assets before making a purchase decision. A stock trading at a price below the book value allows investors to invest their funds in that particular security.
• Using the book valuation calculation can display how much a commercial enterprise or an asset is worth, primarily based on data, as opposed to hypothesis or opinion. Therefore, it's far taken into consideration an incredibly correct degree of price. This way, it may be beneficial while looking to research greater approximately an employer or discover shares at an honest price

Disadvantages of Book Value Accounting

Some of the disadvantages are:

• Since the accounting values are reported on a quarterly/annual basis, investors only get to know about the change in values after the reporting has been done.
• The method has certain adjustments that need to be made, such as depreciation expenses which may be difficult to interpret for an uninformed investor. The investor might need financial statements of many years to understand the impact of depreciation on the asset’s value.
• BV of an asset does not include the impact on the entire claim on the asset and its future selling price. If miscalculated, BV can give misleading information (asset valued higher or lower than its market value).
• Considered to be a flawed method for asset valuation as it is believed that the asset’s value can be written down at the management’s discretion, and businesses can hide the assets and liabilities from the balance sheet so that they don’t reflect on the financial statements.
• As more importance is given to intangible assets and intellectual property rights, it raises concern about the fairness of the book valuation method, as such assets are now playing a pivotal role in determining the firm’s profitability.

Book Value Per Share (BVPS)

Book Value Per Share (BVPS) is a way to calculate the BV per share of an enterprise primarily based on an organization's common shareholder equity.

In the event of the dissolution of an organization, the book value per share (common shares) issued by the organization represents the dollar value of the remaining equity after all the assets are liquidated and liabilities are paid off.

The book value of security also refers to the value determined by the difference between the purchase price of the security and any expenses on trading costs and service fee charges.

The market value of shares can be compared to the book value if shares are theoretically undervalued (if they sell at less than BV) or overvalued (if they sell at more than BV).

The term book value per share is also used to draw differences between the market value and the asset’s accounting value which is strongly influenced by the depreciation and historical costs. The term is often referred to as the carrying value of an asset.

Book value per share can also be obtained by dividing the total value of shareholder’s equity by the total number of common shares issued by the firm.

For example, the value per share of Company X with shareholders’ equity of $500,000 and 10,000 common shares in the market would be 500,000/10,000, i.e., $50 per share.

What Is Fair Value?

In finance, fair value refers to the current price of the asset or security, the intrinsic value of an asset, the price that could be realized from its sale, or the price paid for the transfer of liability between the parties on a particular date. 

For example, the FV of a security traded on a stock exchange is the value determined by market forces influencing the prices, such as demand and supply, and other macroeconomic factors, such as inflation, economic growth, etc.

In the accounting world, fair valuation refers to the estimated value of different assets and liabilities on an organization's balance sheet. It refers to the broad value of an asset and is hence different from the market value, which is merely the asset's market value.

In the most general sense, fair value indicates the potential value of an asset or a price assigned to various goods and services while considering its utility, supply, demand, and competition for the product.

Since the price of a stock at a stock exchange is determined by the bid-ask spread, which implies the buy-sell price, the price is immensely affected by investor demand and supply. Thus, the stock exchange is a reliable platform for determining the FV of assets.

Fair Value Advantages

The fair value method has several advantages, which are listed as follows:

1. Accurate Valuation 

One of the most significant advantages of fair value accounting is that the value we arrive at in the financial statements is an accurate valuation of the firm’s assets and liabilities.

As the value of an asset or liability fluctuates, the company reflects the changes in the financial statements by revaluing them to show what price the firm would fetch if the asset is sold or the amount it would have to pay for the liability.

Moreover, a fall in the valuation leads to a reduction in the asset's value. However, it is beneficial in the case of a liability as the firm will have to pay less for the liability.

2. True and Fair Income

As fair valuation accounting enables the firm to reflect the actual values of assets and liabilities, it reduces its potential ability to manipulate its financial performance (income statement reflecting net income) and balance sheet.

For instance, companies might arrange asset sales at a given point to reflect the gains or losses to increase or decrease their net income in a particular reporting period.

However, fair value accounting does not allow the firm to do that, as the gains or losses arising from price fluctuations are recorded in the period in which they occur.

As a result, firms cannot use loss on revaluation of a given asset sold in one period to reduce the profits of another period which would have helped them save taxes.

Fair Value Disadvantages

Fair value accounting has the following disadvantages:

1. Impact of market factors 

As an asset is constantly being revalued downwards (fall in value), it may adversely affect the market.

For example, when an asset is revalued downwards, the falling value of the asset could lead to the firm receiving an even lower price for its asset in the open market.

Without valuation markdown, compulsory for FV accounting, companies may not sell the asset in a down market to prevent a further reduction in the valuation of the asset.

As time passes by, the value of the asset might increase again, which would therefore aid the firm in preserving its value.

2. Value Reversal
Fair value accounting presents several hardships to companies and even to the users of financial statements. First, market conditions in which the firm operates might fluctuate frequently and become volatile.

If the companies use a fair value method, they have to revalue their assets and liabilities in volatile conditions, thereby leading to significant price fluctuations.

Thus, the firms will have to wait for the market conditions to stabilize, leading to temporary gains or losses, which is why at times, fair value accounting provides misleading information.

Ways to Calculate Fair Value

There are several ways to determine the fair value of assets and liabilities, and they are listed as follows:

1. Using Comparable Information

The fair value of different assets can be determined by publicly available information.

For example, the fair value of a share can be determined by the closing value of a stock as published in a newspaper. For instance, a share with a closing value of $14 will provide a fair value of 1000 shares at $14,000.

The fair value of a real estate can be determined by comparing the prices of similar properties in the neighborhood. For example, if three houses of the same size are sold at a given price, the fourth house can be valued by using the average of the others.

2. Using Cash Flows  

Firms can use cash flows generated by investment and calculate their present value by discounting the cash flows to the current date.

For example, an investment worth $100,000 in a project for five years is expected to generate $40,000 per year for the next five years. So, the present value of the investment after discounting cash flows at a 10% rate will be $51631.47

By using the discounted cash flow method, firms can calculate the present value of the investment to decide whether the investment will be profitable or not.

Book Value Vs. Fair Value

Although book value and fair value are two different methods of valuing a company's assets and liabilities, both ways are used by investors under certain circumstances, and both methods significantly differ in their calculations.

Book value, in simple terms, refers to the firm's value, which is reflected in its books of accounts. It is referred to as the net asset value, which is the difference between the firm's assets and liabilities.

A company's book value also refers to the amount of money that the shareholders would receive upon the firm's liquidation after all the firm's liabilities have been paid off.

On the other hand, the company's fair value refers to the market value of the firm's stock being traded on the market. It is calculated by multiplying the value of an individual share price by the number of outstanding shares of the company.

Although both methods arrive at different valuations, it is upon the investor's preference to choose a specific valuation to make their investment decision. Moreover, the investor can combine the information provided by both methods to arrive at a specific decision.

Researched and authored by Mehul Taparia | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Assertions in Auditing
• Assurance Services
• Net Book Value
• Net Income
• Profit Margin