|Book value is an accounting concept.
It is simply the amount that the company's assets
(net of depreciation, depletion and amortization)
and total liabilities -- as carried on the company's
balance sheet. (Sometimes book value is referred
to as net book value, net worth or
shareholders' equity.) This balance sheet figure
does not measure the firm's earnings potential and
often diverges from the market value of its net
assets. Rarely is book value alone used by professional
business valuators, though it becomes relevant when
specified as a valuation measure in a contract or
Historical costs. Generally,
the company's assets are stated as historical
costs. For example, land acquired 20 years ago
for $300,000 is carried on the books at $300,000,
even though its current market value may be significantly
more. In addition, book value reflects the "capitalized"
cost of an asset less accumulated depreciation,
depletion or amortization. This means that a piece
of equipment acquired for $60,000 and expected
to have a 10 year life will have a book value
of $36,000 after 4 years, assuming straight-line
depreciation of $6,000 per year. This value says
nothing about the equipment's salvage value, replacement
cost or productive value to the business.
Corporations can distribute their assets to
shareholders in a variety of ways—paying
dividends, capital (non-earnings) distributions,
and stock redemptions and repurchases. Nearly
all corporation statutes, however, set limits
on when corporate distributions are legally authorized.
Some jurisdictions use so-called “balance
sheet tests” to decide when distributions
are authorized. As the name implies, these tests
use entries made on the corporation’s balance
sheet to evaluate whether specified accounts are
sufficiently large for a particular distribution
to be made. Of course, this book value measure
of a company’s financial condition almost
invariably bears little resemblance to reality.
Supporters of “balance sheet tests”
generally concede that historical cost measurements
fail to account for the usually higher going-concern
value of the company, but they stress that asset
values provide creditors a valuation “floor”—a
guarantee of at least a minimal amount “legal
Though these statutory balance sheet tests are
falling out of favor in many states, they still
linger on in some key jurisdictions—most
notably Delaware. See Del.
GCL § 170 (dividends), §
Critique of book value. Book
valuation suffers from a number of defects:
- Accountants tend to be conservative and do
not "write up" the book value of assets
to reflect appreciation or an asset's current
- Many assets (such as equipment) are depreciated
on the accounting books and may have minimal
book value, even though they have significant
market value and contribute significantly to
- Sometimes depreciation is accelerated to take
advantage of favorable tax rules -- for example,
R&D equipment can be depreciated over 5
years even though its useful life might be 30
- Some extremely valuable assets (such as trademarks
and customer goodwill) and terribly relevant
liabilities (such as pending lawsuits or environmental
claims) are not reflected on the books at all.
Compare the book value of a publicly traded company’s
common stock as reported on its balance sheet
to the market price. [Look at the attached balance
sheet of General Electric (from 2001 annual report)].
Its common stock had a book value of $14.84 per
share. Nonetheless, on the New York Stock Exchange,
the company's shares never traded below $30 per
share during the company’s 2001 fiscal year.
Book value for GE, as is true for many companies,
has no relation to the value investors place on
Nonetheless, perhaps irrationally, many investors
consider book value to be a floor below
which stock prices should not fall. In fact, a
company with small or even negative book value
may be paying significant dividends -- something
which normally increases a company's value.
[example of book value difference between inventory
carried using LIFO versus FIFO]
Does book value every play a significant role
in major business valuations. Amazingly, yes.
A startling example can be found in the 1998
merger of NationsBank (Charlotte) into the old
BankAmerica (San Francisco) -- now combined as
Charlotte’s Bank of America. One of BankAmerica’s
assets was a portfolio of bonds with a book value
of $20 billion. During the time leading up the
merger these bonds had fallen in value by hundreds
of millions of dollars. What value was reported
to the NationsBank and BankAmerica shareholders
who had to approve the merger?
Answer: Book value! The shareholders
did not know that this investment was hemorrhaging
money until after the merger was consummated.
Was this an example of corporate fraud? Not at
all. National banks are subject to a special regime
of financial disclosure regulation under federal
law—different from the accounting standards
under GAAP imposed by FASB and the SEC. The banks
were acting well within these special reporting
requirements. Martin Mayer, a fellow at the Brookings
Asked in October why the bank continued to
carry its Shaw investment [the bond portfolio]
at cost in August, when the losses in the deal
became overwhelmingly apparent, a spokesman
said the bank had believed that the values would
come back with the passage of time—and,
anyway, the Comptroller of the Currency, the
bank's federal supervisor, had known all about
it. If Shaw as an investment company had tried
to value its holdings in the joint venture at
cost, somebody could have gone to jail. But
the bank could do so, because banking regulators
have long permitted banks to state their assets
at "historic cost," without reference
to market value.
Bonds held in a bank's trading portfolio,
as distinguished from bonds in its investment
portfolio, must be carried at market price,
but the bank itself decides which portfolio
is which. In an activity called cherry-picking,
bonds that show a profit can be moved into the
trading account and sold to improve reported
earnings while bonds that show a loss are slotted
into the investment account and carried at cost.
To keep bonds in the investment account, a bank
need merely declare an "intention"
to hold the paper to maturity. The chief accountant
of the Securities and Exchange Commission in
the late 1980s expressed his distaste for this
brand of "psychiatric accounting,"
but banks are supervised by banking regulators,
not by the SEC.
Martin Mayer, “BankAmerica
Disaster Arose From a Lack of Standards,”
Wall St. J., A22 (Oct. 27, 1998).