{"id":11179,"date":"2020-07-09T08:30:00","date_gmt":"2020-07-09T12:30:00","guid":{"rendered":"https:\/\/einvestingforbeginners.com\/?p=11179"},"modified":"2022-07-08T14:22:51","modified_gmt":"2022-07-08T18:22:51","slug":"market-vs-book-value-argument","status":"publish","type":"post","link":"https:\/\/einvestingforbeginners.com\/market-vs-book-value-argument\/","title":{"rendered":"Valuation Basics: Market vs Book Value \u2013 and The Argument for Both"},"content":{"rendered":"\n

When performing a DCF valuation, you must <\/strong>make a distinction between using market vs book value<\/strong> for debt. It is a critical part of calculating the weighted average cost of capital (WACC).<\/p>\n\n\n\n

The easy way<\/span>, of course, is to just use book value of debt<\/span> from the company\u2019s balance sheet and be done with it. The problem is that this can lead to unbalanced weights for the WACC calculation. It\u2019s a quick shortcut, and seems harmless, particularly when analyzing companies with low leverage.<\/p>\n\n\n\n

However, using this lazy approach can be dangerous<\/mark><\/strong> in either understating or overstating the cost of debt in the overall WACC equation. That will ultimately distort the discount rate used in the valuation process.<\/p>\n\n\n

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\"market<\/a><\/figure><\/div>\n\n\n

Market value vs book value is a simple concept. Take equity for example.<\/p>\n\n\n\n

Market vs Book Value (Equity)<\/h2>\n\n\n\n

Market value of equity =<\/strong> how much the equity is worth in the market. In the stock market, this means the market capitalization.<\/p>\n\n\n\n

Book value of equity =<\/strong> how much shareholder\u2019s equity is on the books for the business. This doesn\u2019t necessarily equal market value, as various equity\/assets can have different earning power and value.<\/p>\n\n\n

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\"\"<\/figure><\/div>\n\n\n

Oftentimes these two metrics are used as a comparison to approximate the expensiveness of equity (such as a common stock) in a simple ratio called the Price to Book Value (P\/B) Ratio, calculated as (Market Value \/ Book Value).<\/p>\n\n\n\n

Now let\u2019s look at the difference between market vs book value of debt.<\/p>\n\n\n\n\n\n\n\n

Market vs Book Value (Debt)<\/h2>\n\n\n\n

Market value of debt =<\/strong> how much the debt would trade in the secondary market. In the case of corporate bonds, this would depend on current interest rates (opportunity cost of buying other interest-bearing investments) and the perceived risk of the underlying (resulting in higher premium).<\/p>\n\n\n\n

Book value of debt =<\/strong> how much the debt was worth when issued (and as recorded in the books). Utilized for both liabilities like debt and fixed assets like Property, Plant, and Equipment.<\/p>\n\n\n\n

Notice that:<\/p>\n\n\n\n

  1. The difference between market and book value is noteworthy because of the way accounting standards are enforced today. Assets and liabilities are recorded at cost and are depreciated or amortized over time, but aren\u2019t adjusted upwards even if their true market value has increased (i.e. real estate).<\/li>
  2. Market value is a forward looking metric<\/span>.<\/li>
  3. Book value is a backwards looking metric<\/span>.<\/li><\/ol>\n\n\n\n

    The Argument for Using Market Value in Cost of Debt Calculations<\/strong><\/h2>\n\n\n\n

    Like I said, using book value of debt for a cost of debt formula in a WACC is easy to do, and widely done at times, because it\u2019s another involved step in a long DCF process.<\/p>\n\n\n\n

    However, the entire point of calculating WACC is to estimate how much a company can raise in capital in order to fund new investments and future growth.<\/p>\n\n\n\n

    Looking at the debt side, that means determining how much new capital would cost (in the form of an interest rate). How expensive debt was to raise for the company in the past can be helpful in determining additional issuances IF<\/strong> the company has a similar risk profile\/liquidity\/financial strength.<\/p>\n\n\n

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    \"\"<\/figure><\/div>\n\n\n

    But the cost of raising new debt capital may be higher or lower than where the company was able to raise capital in the past if interest rates have changed, or other competing investments have had changes in yields, or if inflation has affected the value of money.<\/p>\n\n\n\n

    In other words:<\/p>\n\n\n\n