The balance sheet provides the book value of assets, liabilities, and equity. The book value of equity is often an inaccurate assessment of the actual value of a firm’s equity, because:
- Based on historical cost
- Not all assets and liabilities included, and others maybe understated and/or overstated
- Intangible assets such as patents and goodwill, brand value, expertise
- Continent liabilities: Law-suits not routinely disclosed
The market value is the current price at which the assets, liabilities, or equity can be brought or sold.
This leads us to define the book value and market values of equity:
Book value of equity:
- Represents an accounting measure of the net worth of the firm
- Consists of shareholders’ ownership claims: share capital and retained earnings
Market value of equity:
- Also referred to as market capitalization.
Note that the book value of equity can be negative (liabilities exceed assets), and that a negative book value of equity is not necessarily an indication of poor performance. Successful firms are often able to borrow in excess of the book value of their assets because creditors recognize that the market value of the assets is far higher.
Market-to-Book Ratio
We can compare the market and book values of a company’s equity using the market-to-book ratio:
- The market-to-book ratio for most successful firms substantially exceeds 1, indicating that the value of the firm’s assets when put to use exceeds their historical cost (or liquidation value).
Enterprise Value
The enterprise value of a firm assesses the value of the underlying business assets, unencumbered by debt and separate from any cash and marketable securities:
- A more accurate representation of a firm’s value
- Different from Total Assets (on balance sheet) and market capitalization (equity value)
- Net cost to take over the business (cost to buy all equity and pay off its debts, but receiving its cash)