“Price is what you pay; value is what you get.”
Part of the process of evaluating a company for investment is determining the value of its assets, liabilities, and equity. Most of us are familiar with assets such as accounts receivable and liabilities such as debt. But how many of us understand equity and how to determine the value of that equity?
The book value of equity tells us how much we are paying for our investment because, as owners, that is what we “own.” When the company repurchases shares, it is buying back its equity, which helps improve our ownership value. Dividends are distributions of the equity of the company to shareholders.
Both of these methods are great ways to generate shareholder returns, but let’s look a little closer at a company’s equity to get a better sense of what we own and its value.
In today’s post, we will learn:
- What is the Book Value of Equity?
- Market Value vs. Book Value of Equity
- The Parts that Makeup Equity
- How to Calculate Book Value of Equity From the Balance Sheet
- Investor Takeaway
Okay, let’s dive in and learn more about the book value of equity.
What is the Book Value of Equity?
The book value on a company’s balance sheet represents the funds that belong to shareholders. It is all the company’s money for shareholders and is available for distribution in buybacks or dividends.
The classic accounting formula to balance the balance sheet is as follows:
Assets = Liabilities + Shareholders’ Equity
Meaning the assets needs to equal the sum of the company’s liabilities and shareholder equity. That means determining the value of the equity in the company is to subtract liabilities from assets, which will give us shareholder equity.
Assets – Liabilities = Shareholders’ equity
Sometimes book value of equity is confused with the market cap, which denotes its value based on the number of shares outstanding and its market price.
Berkshire Hathaway market cap = $285.42 per share x 2,299.9 million shares outstanding = $656.43 billion
But, looking at the current balance sheet, we see the company has a current shareholder’s equity of $456.17 billion.
When most analysts refer to the company’s book value, they refer to a combination of the debt and the company’s equity. In general, the companies expected to grow revenues and profits have a lower book value of equity than their market value of the equity. That is because the company’s assets can grow more revenues and profits, and the market values that growth.
On the flip side, if a company has higher shareholder equity than its market cap, it is not expected to have much future growth.
When we calculate ratios such as return on equity (ROE), or debt to equity, the equity figure we use for those calculations comes from the book value of the equity.
Those metrics help us determine the value of the company’s income and debt levels compared to the shareholders’ equity, the company’s owners’ portion.
We observed with Berkshire Hathaway, the company has a market cap higher than its equity, but this is not always the case, even with strong, profitable companies, for example:
Starbucks is carrying a negative book value of equity because it has negative shareholders’ equity. They have used all of their retained earnings to buy back shares over the past few years and have drained their equity. That doesn’t mean Starbucks is on the verge of bankruptcy, but it could lead to trouble if it continues for an extended period.
Looking at another company, Oracle, we can see it shareholders’ equity has taken a downward trend over the last five years:
- 2017 – $53.8 billion
- 2018 – $46.3 billion
- 2019 – $21.7 billion
- 2020 – $12.7 billion
- TTM – $9.6 billion
All because the company is diverting its retained earnings to share repurchases, in part to give back to the shareholders, but also to keep the earnings per share at a reasonable number and not give investors another reason to flee. With the company experiencing flat to slow revenue growth, they need earnings to be growing, and one way to accomplish this is to reduce the share count.
All the more reason to understand the book value of equity and look at more than just the company’s top-line growth. I would bet without looking too closely that management compensation is tied to earnings growth too. But that is a subject for another time.
Market Value Vs. Book Value of Equity
In general terms, the market value of a company is the value of the company in the market. For example, if Berkshire trades at $284.92 and has outstanding shares of 2,299.9 million, the company has a market cap of $656.6 billion. That equals the market value of the company.
But that market value encompasses all the aspects of the company, such as its assets, cash, revenues, costs of operations, and debt. The market value of a company depends on what the market is willing to pay for Berkshire. If the market is willing to pay less, the market value drops, and vice versa.
The book value of the equity is the amount of value of the company after we subtract all the assets and liabilities. Equity or shareholders’ equity tends to move far less than the market value of the company.
For example, if you own a volatile stock like Palantir, you will see wild fluctuations in the market value from day to day. But the company’s equity value only changes every quarter, and the changes tend to be gradual.
As we mentioned earlier, the market value tends to be higher than the book value of the equity. The market value is a function of the daily actions in the market, where the book value of equity is an accounting function and will only adjust during each quarterly or annual report. Another way to think about the book value of equity is it represents the company’s value in the event of a liquidation. In that circumstance, the shareholders would receive the value at the sale of the equity.
The book value of the company’s equity is a part of the price to book value ratio, or the price to book calculations.
The price to book and book value per share calculations are common valuation techniques used in the analysis of financials, such as banks and insurance companies.
The Parts That Makeup Equity
The company’s equity is made up of a few main parts; in this section, I would like to take a quick look at each line item to get a better understanding of the makeup of the equity of Amazon.
The above snippet is from the company’s latest quarterly report (10-q) dated March 31, 2021.
There are four major components of the equity of Amazon, which are the owner’s contributions; that’s us the investors.
Common stock and Additional Paid-in Capital
The common stock is the portion of equity capital at the par value of the shares, $0.01, which equals $5 million, which we can see as the total amount of shares issued equals 5,000 million. The additional paid-in capital is the extra capital paid above the par value of common stock issued. The additional paid-in capital can grow when Amazon issues shares or shrink when repurchasing shares.
Treasury shares or stock, not to be confused with the Treasury stocks from the US government, are reacquired Amazon stock. These previously outstanding shares are repurchased from shareholders by Amazon. Once the purchase is complete, the outstanding shares on the market decrease, but the company holds them on its balance sheet. They are not considered when distributing dividends or in earnings per share calculations.
Treasury shares reduce the value of the company’s equity on the balance sheet, and the balance sheet will tell us if the value of the shares is at cost or par. In Amazon’s case, they list at the cost of $1.837 billion. A fun fact, Amazon has not changed its treasury stock since 2012; it has remained at the current level since then.
Retained earnings are the portion of the net income or bottom line of Amazon that is not paid out in dividends. When Amazon generates a profit, it grows the retained earnings, and when they experience a loss, it shrinks the retained earnings.
When a company generates profits, it gives the management more options to reinvest in the business, pay down debt, or distribute a dividend.
A growth company such as Amazon prefers to use its earnings to reinvest in the company, as they can generate a better return than issuing a dividend.
Looking a bit more closely at Amazon’s retained earnings, we can see a growth of 46.59% annually, which is higher than the equity at 31.15%.
Retained earnings is a good line item to pay attention to because it tells us what the management is doing regarding growth or returning capital to shareholders.
Retained earnings comprise most of the shareholders’ equity of companies, along with paid-in capital.
Any monies not paid to shareholders remain in the retained earnings account, often building up over time.
Other comprehensive income comprises revenues, expenses, gains, and losses that are not included in the income statement. Much of these revenues, gains, expenses and losses are not realized yet. They stem from investments in bonds, equities, foreign exchange hedges, pension plans, and other miscellaneous items.
Because of accounting standards, none of the above can be listed on the income statement. A common example is the bond portfolio that a company carries that has not matured and hasn’t redeemed them.
Typically, the OCI (other comprehensive income) is not a large part of the book value of equity. Instead, it points out other methods of income or losses for the company.
How to Calculate Book Value of Equity From the Balance Sheet
There are several ways to calculate the book value of equity. The first and easiest is to subtract liabilities from assets, and the amount leftover is the book value of the equity. For example:
Total Liabitities (-)
Super easy, huh? You can also look at the bottom of the balance sheet of Amazon and find the line item:
Even easier, huh?
But, to understand the components of the book value of equity, we should take the extra step and outline the items in a quick chart to see how it breaks down.
Other comprehensive income
Notice, we arrive at the same number that Amazon reports on the balance sheet, but the idea of looking at the individual numbers gives us a sense of what the company is doing with “our” money.
Remember that shareholders’ equity is the investor’s money; it is our portion of the company’s value. If the management is reinvesting poorly, we need to know that it would be better to distribute a dividend than waste it on poor projects.
That is why it is important to study the balance sheet to help investors determine what is driving the business’s growth, where that growth is coming from, and what management is doing with those funds.
For example, Amazon’s Jeff Bezos is an amazing allocator of capital, and he and the company drive growth from its revenues, which all compounds and drives even more growth. Warren Buffett does the same for Berkshire, and notice neither company pays a dividend.
In his shareholder letters, Buffett explains multiple times that finding a company that allocates capital well is one of the hidden secrets to finding great companies. One of his best investments, Coke, had a CEO who was superb at allocating capital for the company and helped grow them into the superpower they are in the beverage business.
Understanding the book equity of the company we are investigating helps us determine whether the market under or overvalues the company. It also tells us in a quick glance whether it is a strong company with a positive value. If we see negative book value of equity, such as with Starbucks, we need to dig deeper to understand its situation. In some cases, it might mean a short-term issue; in others, it might be a red flag.
With the rise in intangible assets and internet-based companies such as Facebook, Netflix, and Google, some of the importance of assets has shifted. Companies such as Facebook generate revenues differently from a company like Lockheed Martin, and treating them the same is not logical.
There is a trend among analysts to treat expenses such as research and development (R&D) as long term investments, which means that the company’s long term assets impact each company’s value differently.
Book value of equity tells us how much net income is left over, how much paid-in capital the company retains from its IPO, or different stock offerings, all of which gives them additional funds to grow the company.
Studying the book value of equity can tell us how well a company allocates its capital, and finding a CEO who does this well will lead to growth for the company and you, as the investor.
With that, we will wrap up our discussion on the book value of equity.
As always, thank you for taking the time to read this post, and I hope you find something of value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,