What is the Book Value of Equity?
The Book Value of Equity is the amount received by the common shareholders of a company if all of its balance sheet assets were to be hypothetically liquidated.
In comparison, the market value refers to how much the equity of a company is worth according to the latest prices paid for each common share and the total number of shares outstanding.
- What is the formula used to calculate the book value of equity?
- How does the book value of equity differ from the market capitalization?
- Which is the more accurate measure of value: the book value or market value?
- How can the book value of equity be used to find undervalued securities?
Table of Contents
Book Value of Equity Formula
The book value of equity, or “Shareholders’ Equity”, is the amount of cash remaining once a company’s assets have been sold off and if existing liabilities were paid down with the sale proceeds.
As implied by the name, the “book” value of equity represents the value of a company’s equity according to its books (i.e. the company’s financial statements, and in particular, the balance sheet).
In theory, the book value of equity should represent the amount of value remaining for common shareholders if all of the company’s assets were to be sold to pay off existing debt obligations.
The formula for the book value of equity is equal to the difference between a company’s total assets and total liabilities:
Book Value of Equity = Total Assets – Total Liabilities
For example, let’s suppose that a company has a total asset balance of $60mm and total liabilities of $40mm. The book value of equity will be calculated by subtracting the $40mm in liabilities from the $60mm in assets, or $20mm.
If the company were to be liquidated and subsequently paid off all of its liabilities, the amount remaining for common shareholders would be worth $20mm.
Book Value of Equity Line Items
Common Stock & Additional Paid-In Capital (APIC)
Next, we’ll walk through the main parts that make up the equity section on the balance sheet.
The first line item is “Common Stock and Additional Paid-In Capital (APIC)”.
Common stock refers to equity capital issued in the past, recorded at the par value of the shares (the value of a single common share as set by a corporation), while the APIC section is related to the extra capital paid in excess of the par value of common stock issued.
APIC increases when a company decides to issue more shares (e.g. secondary offering) and declines when repurchasing shares (i.e. share buybacks).
When companies generate positive net income, the management team has the discretionary decision to either:
- Reinvest into the Operations of the Business
- Issue Common or Preferred Dividends to Equity Shareholders
For high-growth companies, it’s far more likely that earnings will be used to reinvest into ongoing expansion plans.
But for low growth companies with limited options for reinvestments, returning capital to equity holders by issuing dividends could potentially be the better choice (versus investing in high-risk, uncertain projects).
If a company consistently performs well from a profitability standpoint and decides to reinvest into its current growth, the retained earnings balance will increasingly accumulate over time.
To investors, retained earnings can be a useful proxy for the growth trajectory of the company (and return of capital to shareholders).
Next, the “Treasury Stock” line item captures the value of repurchased shares that were previously outstanding and available to be traded in the open market.
- Following a repurchase, such shares have effectively been retired and the number of outstanding shares decreases.
- When a company distributes dividends, these shares are excluded.
- Repurchased shares are not factored in when calculating basic EPS or diluted EPS.
Treasury stock is expressed as a negative number because the repurchased shares reduce the value of a company’s equity on the balance sheet.
Other Comprehensive Income (OCI)
Lastly, the “Other Comprehensive Income (OCI)” line item can contain a wide variety of income, expenses, or gains/losses that have not yet appeared on the income statement (i.e. that are unrealized, not redeemed).
The line items frequently grouped into the OCI category stem from investments in securities, government bonds, foreign exchange hedges (FX), pensions, and other miscellaneous items.
Apple (AAPL) Equity Example
Apple Balance Sheet (Source: WSP Financial Statement Modeling Course)
Book Value vs Market Value of Equity
The book value of equity is a measure of historical value, whereas the market value reflects the prices that investors are currently willing to pay.
Typically, the market value almost always exceeds the book value of equity, barring unusual circumstances.
One common method to compare the book value of equity to the market value of equity is the price-to-book ratio, otherwise known as the P/B ratio. For value investors, a lower P/B ratio is frequently used to screen for undervalued potential investments.
While the market value accounts for investor sentiment regarding the growth and profit potential of the company, the book value is a historical measure used for accounting purposes (and for consistency and standardization across all companies)
The book value of equity is the net value of the total assets that common shareholders would be entitled to get under a liquidation scenario.
But the market value of equity stems from the real, per-share prices paid in the market as of the most recent trading date of a company’s equity.
Market Value < Book Value of Equity
Even though it is plausible for a company to trade at a market value below its book value, it is a rather uncommon occurrence (and not necessarily indicative of a buying opportunity).
Remember that the markets are forward-looking and the market value is dependent on the outlook on the company (and industry) by investors.
If a company’s market value of equity is lower than its book value of equity, the market is basically saying that the company is not worth the value recorded on its books – which is unlikely to occur without a legitimate cause for concern (e.g. internal problems, mismanagement, poor economic conditions).
But in general, most companies expected to grow and produce higher profits into the future are going to have a book value of equity less than their market capitalization.
The equity value recorded on the books is significantly understated from the market value in most cases. For example, the book value of Apple’s shareholders’ equity is worth around $64.3 billion as of its latest 10-Q filing in 2021.
Apple Filing – Quarter Ending June 26, 2021 (Source: 10-Q)
However, Apple’s market value of equity is well over $2 trillion as of the current date.
Generally speaking, the more optimistic the prospects of the company are, the more the book value of equity and market value of equity will deviate from one another.
From the opposite perspective, the less promising the future growth and profit opportunities seem, the more the book and market value of equity will converge.
Excel File Download
Now, we’re ready to move on to an example forecast of the “Book Value of Equity” line item on the balance sheet. Fill out the form below to get access to the file that goes along with the exercise.
Book Value of Equity Example Calculation
For our modeling exercise, we’ll be projecting the “Total Equity” line item for three years with roll-forward schedules.
By explicitly breaking out the drivers for the components of equity, we can see which specific factors impact the ending balance.
The ending equity calculation that we’re working towards consists of adding three pieces:
- Common Stock & APIC
- Retained Earnings
- Other Comprehensive Income (OCI)
The following assumptions will be used for “Common Stock & APIC”:
Common Stock & APIC
- Beginning Balance (Year 0): $190mm
- Stock-Based Compensation (SBC): $10mm Per Year
Since the issuance of compensation in the form of stock-based compensation increases the account balance, we’ll add the SBC amount to the beginning balance.
Next, the beginning balance for the next period (Year 2) will be linked to the ending balance of the prior period (Year 1).
The process will be repeated for each year until the end of the forecast (Year 3), with the assumption of an additional $10mm stock-based compensation consistent for each year.
From Year 1 to Year 3, the ending balance of the common stock and APIC account has grown from $200mm to $220mm.
As for the “Retained Earnings” line item, there are three drivers that affect the beginning balance:
- Net Income: The accounting, after-tax profits generated by a company (“bottom line”).
- Common Dividends: Payments issued to common shareholders from retained earnings.
- Share Repurchases: Shares repurchased by the company either in a tender offer or just in the open market – here, share repurchases (i.e. treasury stock) are modeled within retained earnings for simplicity rather than explicitly creating a contra equity account.
The following operating assumptions will be used:
- Retained Earnings (Year 0): $100mm
- Net Income: $25mm Per Year
- Common Dividends: $5mm Per Year
- Share Repurchases: $2mm Per Year
While net income each period is an inflow to the retained earnings balance, common dividends and share repurchases represent cash outflows.
As for “Other Comprehensive Income (OCI)”, we’ll simply apply the $6mm assumption in Year 0 across the next two years.
Other Comprehensive Income (OCI)
- Other Comprehensive Income (OCI): $6mm Per Year
In Year 1, the “Total Equity” amounts to $324mm, but this balance grows to $380mm by the end of Year 3.