Book Value

This form of value is the worth of a company based on its financial statements. This means the net asset value of a company, as illustrated in Exhibit 1-2.

Exhibit 1-2: Book value.

Book Value Total Assets Less: Depreciation and Amortization Equals Net Assets Less: Liabilities Equals Book Value
Year	Book Value (1)	Market Value (2)	Surplus over Book Value	Distortion (3)
Purchase	$1,000,000	$1,000,000	Same	None
1	$970,000	$1,000,000	$30,000	3%
2	$940,000	$1,030,000	$90,000	9%
3	$910,000	$1,060,900	$150,900	14%
4	$880,000	$1,092,727	$212,727	19%
5	$850,000	$1,125,509	$275,509	24%
6	$820,000	$1,159,274	$339,274	29%
7	$790,000	$1,194,052	$404,052	34%
8	$760,000	$1,229,874	$469,874	38%
9	$730,000	$1,266,770	$536,770	42%
10	$700,000	$1,304,773	$604,773	46%
(1) Depreciation over 30 years ($30,000 per year) with a $100,000 salvage value
(2) Appreciation rate of 3% per year
(3) Surplus divided by market value

There are some major problems with this definition as presented in Exhibit 1-2. First, it uses accounting principles that do not necessarily reflect realistic conditions. Total assets are adjusted for deprecation and amortization, which are allowances taken to adjust for the decline of the price of an asset. Depreciation is an adjustment of the book value of an asset to allow for wear and tear. For example, assume you had a commercial building that was purchased for $1 million and it was depreciated over a thirty-year period, a salvage value of $100,000. Now suppose that the market price of the building increases at a rate of 3 percent per year. The amount of cash the property could be sold for may be rising, and the book value could be falling, as also illustrated in Exhibit 1-2. Over a ten-year period the distortion in value (surplus over book value divided by market value) grows to 46 percent of market value (Exhibit 1-3).

Exhibit 1-3: Value distortion.

The next issue is that the book value method is based on historic transactions. The value of the building on the books is determined by what the company paid for the property less depreciation (adjustments may be made for improvements over time). The problem is that book value does not look at future growth in value based on changes in demand and the receipt of future cash streams.