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Book Value

Investing Lesson 3 - Analyzing a Balance Sheet


Book Value on Balance Sheet

Book value is a term used to refer to a company's accounting net worth (assets minus liabilities). Book value, or shareholder equity as it is sometimes called, is used to calculate the profitability of a firm using something called return on equity.

Book Value and Shareholder Equity are not quite the same thing. To find a company's book value, you need to take the shareholders' equity and exclude all intangible items. This leaves you with the theoretical value of all of the company's tangible assets (those which can be touched, seen, and felt). For this reason, book value is sometimes also called "Net Tangible Assets".

Net Tangible Assets (or Book Value)

The amount of net tangible assets a company has is particularly important. Since you should always analyze the balance sheet you get directly from the company (as opposed to the ones you find on Yahoo or other financial sites), you may not always have this figure calculated for you. To calculate it, take the total assets and subtract all of the intangible assets such as goodwill. What you are left with is the nuts and bolts of the company; the buildings, computers, telephones, pencils, and office chairs.

In the past, it was generally thought the more assets a company had the better. Over the past twenty years, value investors have come to reject this idea in its pure form; it is actually preferable to own a business that generates earnings on a lower asset base.

Why? Let's say your company earns $10 million a year and has $30 million in assets. My company earns the same $10 million but has $50 million assets. It is generally understood that a relationship exists between the amount of assets a company has and the profit it generates for the owners. If you wanted to double the earnings of your company, you would probably have to invest another $30 million into the company. After the reinvestment, the business would have $60 million in assets and earn $20 million a year.

On the other hand, if I wanted to double the earnings of my company, I would have to invest another $50 million into the business (which would double the assets). After the reinvestment, my business would have $100 million in assets and generate $20 million a year.

What does that mean?

You would have to retain $30 million in earnings to double your profits. I would have to retain $50 million to get the same profit! That means that you could have paid out the difference (in this case $20 million) as dividends, reinvested it in the business, paid down debt, or bought back shares! We will talk more about this in the future.

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This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents. If you have already read this lesson, you can skip directly to the Balance Sheet Quiz.

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