Modified Book Value

 What is Modified Book Value?

Modified Book Value is a business valuation metric for determining a company’s worth after determining the current value of its assets and liabilities in the market. 

In simpler words, modified book value is valuing a company’s assets and liabilities at a Fair Market value regardless of the book value, which is recorded at their original or historical cost.

The updated fair market value of those assets could be a lot of different value than what is recorded in the book at their historical cost.

For example, some specific machinery/plant is recorded at their Historical cost/value, but the current market price of that asset is completely different.

In this method of company valuation, one considers that the company's value can be determined by estimating the value of its assets, which are mentioned in the balance sheet.

Understanding modified book value

A company's modified book value cannot be determined without focusing on and understanding the book value of the company.

A company's book value can be defined as the value of all its assets deducted from all its debts and liabilities. In other words, Modified Book Value is the company's remaining value derived after selling all its assets and paying off all the debt and liabilities.

Investors use this value as a metric to compare with book value and to determine if the company is overvalued or undervalued according to what is shown in the books of accounts.

If we use traditional valuation methods, the value of assets and liabilities of the company will be recorded on the balance sheet by way of calculations only.

According to accounting principles, the value of an asset is recorded at its historical cost, which is the original purchase price, and not at its market value.

Usually, the price of such assets keeps fluctuating over time, which means that its value is quite different from the historical value recorded in the financial accounts such as the Balance sheet.

To better understand this concept, let’s take the following simple example:

The plant, machinery, and manufacturing equipment will likely decrease in value over time since they’re being used and the technology is changing. Eventually, the asset becomes less valuable with time, and the support, like land, would likely increase in value over the period.

Components of Modified Book Value

The calculation of the modified value under this method requires the analysis of the Fixed Assets regardless of whether they’re physical (tangible) assets or intangible assets (not of physical nature).

Below are some examples of a company’s assets and liabilities.

Assets

An asset is a resource owned or controlled by a business or an economic entity/organization. It can be anything used to produce positive economic value for the business or organization. Assets are classified in the following manner:

• Tangible assets
  • Equipment
  • Machinery
  • Factories and building
  • Transport vehicles
• Intangible assets
  • Patents
  • Intellectual Property
  • Copyright 

Liabilities 

A liability can be defined as a future sacrifice of economic benefits by the entity obliged to make to other business entities because of past transactions between them. 

The settlement may result in payment through cash, bank, or by transfer of assets and provision of services or other yielding of economic benefits in the future. Liabilities are what a company owes and have to pay back, maybe in the short term or long term, as per their financial obligation. 

Examples of liabilities are:

• Trade Payables: the amount a company owes to creditors or suppliers.
• Dividends Payable: appropriation of the profit made to shareholders through cash payment.
• Long-term Debt: It is money borrowed from the bank or debentures.

When is Modified Book Value Used?

This modified book value method is the most commonly used method to evaluate distressed companies that are on the edge of bankruptcy and are prone to fail. 

This method adjusts the value of all the tangible assets held by the company one by one to arrive at an adjusted value or modified price of assets.

Current assets like cash in hand and short-term debt are already captured at fair market value according to market price. These can not be modified and are already at the value they can be recorded as presented in the balance sheet.

Calculation of the Modified book value of a company is required when a company is in the situation of facing bankruptcy or is going through some kind of financial problems, or if it is under a huge amount of loan/debt outstanding from creditors or banks so investors and analysts can evaluate the true value of the company.

This method can help creditors and investors to find the actual liquidation value of all assets and the amount of money of a company at which the asset can be sold in the open market, which can be used later by the company to pay for its liabilities and debt.

Finally, suppose the company's modified value after calculation derived from its total assets, including current and noncurrent assets, is less than its total liabilities mentioned in the balance sheet.

In that case, there is a big chance that the creditors who provided the company with loans and finances may go through some loss on their outstanding loans, which are given to the company by those creditors.

How to Compute a Modified Book Value

Modified Book Value helps create a more realistic valuation of a company regardless of what is given in the account books by obtaining the current market value of assets and liabilities. 

Once the updated values are determined, the modified book value is calculated by subtracting the total fair market value of the company’s assets from the total fair market values of its liabilities.

As per this valuation method, the asset values may need to be adjusted to realistic expectations. Some short-term assets like cash would already be recorded at fair market value on the balance sheet.

However, when a company’s accounts receivables represent money receivable by a company on the balance of its debtor for a product that is already sold and is likely not to receive any amount, that amount may need to be discounted.

For example, a balance of the outstanding accounts receivable may be discounted to a percentage of 90 days or older because it is highly unlikely that the company will recover it.

There will likely be an increase in some assets' value from the purchase date. Some other assets' value would likely be reduced with time or depreciation. Finally, the fair market value of assets and liabilities is determined, and modified book value can be determined by subtracting the two totals.

Modified Book Value Advantages and Disadvantages

Being a valuation method like any other, Modified Book Value, too, has its pros and cons. It helps solve multiple problems but still has some drawbacks. 

As advantages, we have:

• Provides In-depth examination of assets: This valuation method includes an in-depth examination of the company or any other business entity. The valuation of individual assets, which the company owns, gives a clear and deep view of the functioning, cash flow, and value generation of the business organization.
• It helps increase negotiating power: If there is a case where later the value of the assets is found to be better than what was stated in the books earlier, then it makes the company more valuable in the view of investors and helps to improve the negotiating power of the company before selling itself to investors.

On the other hand, concerning the disadvantages, we have:

• Cost intensive: One major disadvantage of this method is that it includes a highly cost-associated method because of the multiple calculations one has to perform to use this method. Multiple specialized appraisers may be appointed to perform multiple tasks relating to the valuation process.
• Difficult to perform: For this method, it is difficult for an average investor to access the specific assets and their value of a publicly-traded (public) company. This makes it more difficult for investors to create and determine a fair market valuation of the company’s assets and liabilities mentioned in the balance sheet using only the total amounts recorded on its financial accounts.
• Time-consuming: This method is time-consuming as they have to do a lot of tasks and follow multiple steps to complete the valuation process, making the whole process very long and time-consuming.

Alternate Valuation methods

There are various ways to value a company that investors use. These alternate valuation methods can refer to different methods used to determine the value of an asset or liability. Depending on the context, there can be various alternate valuation methods.

Some of them are mentioned below.

Market Capitalization

This method helps determine the company's aggregate market value, known as the market cap.

It provides a brief idea of the “market value” of the company. To compute it, one has to find the Current Market Price (CMP) of the shares at which it is traded and then multiply it by the total number of outstanding shares in the books of accounts of the company.

It also helps in comparing and categorizing the size of companies among investors and analysts.

Time-Revenue Method

The time-revenue valuation method helps determine the company's maximum value at a particular point in time by calculating the multiple of the current revenue of the company to determine the maximum value for a particular business at that particular period.

Discounted Cash Flow

The discounted cash flow analysis method is used to value the investment of a business entity by discounting the estimated future cash flows for that financial year. It measures a company's expected cash flow from both revenue and expenses.

It helps determine the value of the investment at present and provides the future projection of cash flow based on this method.

Free Resources

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

• Absolute Valuation
• Business Valuation Glossary
• Cash Flow Drivers
• Enterprise Value (EV)
• FCFF vs FCFE