Book Value approach

If you have landed here looking for what book value per share means as a ratio, you want book value. This page is about using it as a method of valuing a business.

Asset based valuation asks a simple question. Forget what the business might earn. What is it made of?

The workbook gives three ways to answer that, and they differ only in what price you put on the assets.

The book value approach uses the price already in the books — historical cost, as the balance sheet records it. The replacement cost approach asks what it would cost to build the same business today. The break-up value approach asks what the pieces would fetch if you shut it down.

Book value comes out in the middle, and it has a special standing. The workbook calls it the floor price — the least value you would attribute to a going concern, a business expected to continue.

Why a floor? Because it counts nothing for the future. It takes no view on growth, on brand, on management. Those things can only add.

Section 14.5 sets out asset based valuation and its three approaches.

The common idea. The value of the equity share is arrived at as the net asset value per share — the total net asset value of the company divided by the number of outstanding shares. The method does not take into account any future value attributable to the business, and considers only the market value of the assets less the liabilities.

The three approaches, and what each prices the assets at:

The formula.

Book Value per Share = Equity Shareholders' funds as per balance sheet ÷ Number of equity shares issued and paid up

The standing of the answer. Under the first method all the assets and liabilities of the company as on the valuation date are considered at historical carrying cost in the books. Book value of a share of a company is normally considered the floor price, or the least value attributable to a going concern business which is expected to continue in business in future.

The exclusion that decides the arithmetic. In the workbook's Illustration 14.4 the revaluation reserve is not included in cash net worth, and the footnote gives the reason: cash net worth does not include revaluation reserve, hence it is excluded from valuation. A revaluation reserve is an upward writing-up of an asset, not money the shareholders put in or the company earned. Including it would price the assets above historical cost, which is the one thing this approach does not do.

What it is not good enough for on its own. Asset based valuation is not considered an independent method. When employed it would more often than not be used in conjunction with other methods, assigning appropriate weightage based on its overall importance in the given valuation context. It is most appropriate for asset heavy businesses and distressed companies facing liquidation, and ideal for financial businesses such as banks and financial or investment companies.

Where it sits among the alternatives. Section 14.6 is the discounted cash flow method, which finds the present value of free cash flow discounted at the weighted average cost of capital, typically forecast for about 5 years plus a perpetual terminal value. Section 14.7 is relative valuation, on multiples such as EV/EBITDA, EV/Sales, P/E and P/BV. Only asset based valuation ignores the future entirely, which is exactly what makes it a floor rather than an answer.

The workbook's own Illustration 14.4 values Alpha Ltd on all three asset-based approaches from one balance sheet, with 10,000 outstanding shares.

A note on the figures. The printed balance sheet in the workbook is headed Rs crore while the amounts are plainly in rupees, and the computations that follow treat them as rupees. The rupee reading is the internally consistent one, so it is used below.

I. Book value.

The revaluation reserve of Rs 15,00,000 sits on the balance sheet and is left out. Had it been included, the answer would have been Rs 1,160 a share — a 15% overstatement produced entirely by a book entry.

II. Break-up value, on the workbook's further information: fixed assets fetch 40% of book value if scrapped, receivables fetch 25% less on liquidation, payables settle 15% lower, and the intangibles — trademarks and patents — would fetch Rs 5 lakh more.

III. Replacement value, on the further information that fixed assets are worth 10% less on a going concern basis and that setting up licences, registrations, approvals and pre-operative costs would take Rs 20,00,000.

Now read the three answers together.

Three methods, one balance sheet, and the book value sits three times the break-up value. That is the floor-price idea made concrete: if Alpha keeps trading, Rs 1,010 is the least you would pay; if it stops trading tomorrow, Rs 327.50 is what is left.

And the replacement figure is not a fourth opinion on the same thing. It is an enterprise value, so the debt would have to be deducted before it could be compared with the other two.

Chapter 14 (Valuation), section 14.5 on Asset based Valuation, introduces the three approaches and works all three in Illustration 14.4. Sections 14.6 and 14.7 then give the DCF and relative valuation alternatives, and section 14.4.1 supplies the enterprise value versus equity value distinction that the replacement figure turns on.

Expect the three-way matching question: which approach uses historical carrying cost (book value), which uses replacement cost as-is-where-is (replacement), and which uses salvage value on shutdown (break-up). Expect the floor-price line — book value is the least value attributable to a going concern. The formula is examinable, and so is the treatment of the revaluation reserve, which is excluded. The higher-order point worth carrying is that asset based valuation is not an independent method and is used with appropriate weightage alongside others.

• Exclude the revaluation reserve. The workbook's footnote is explicit, and including it inflates the answer. This is the single easiest mark to lose in Illustration 14.4.
• Book value gives an equity value; replacement cost gives an enterprise value. The workbook labels them so. Comparing them per share without deducting debt is wrong.
• Book value is the floor for a going concern, not the floor full stop. For a distressed company the relevant floor is the break-up value, which in Illustration 14.4 is under a third of book value.
• Replacement cost adds the cost of establishing the business as a going concern, not merely the cost of the assets. That is why it suits businesses with high entry barriers or set-up costs.
• Asset based valuation takes no account of future value. A question asking which method ignores growth prospects is asking for this one.
• It is not an independent method. Answering that a company can be valued on book value alone contradicts the workbook.
• It is ideal for banks and financial or investment companies, and for asset heavy and distressed businesses — not for a start-up, whose book value the workbook elsewhere notes can even be negative once accumulated losses wipe out reserves.