Book value is the amount that investors would theoretically receive if all company liabilities were subtracted from all company assets; this leaves a residual amount available for distribution to investors. The concept is used to establish the minimum amount that a business should be worth, which can be considered the lowest price at which the sum total of its stock should trade.
The book value of equity concept is not entirely valid, since it does not account for undocumented assets and liabilities, and also assumes that the market values of assets and liabilities match their carrying amounts, which is not necessarily the case.
There are several variations on how to compute the book value of equity, which are:
- Classical approach. Simply subtract liabilities from assets to arrive at book value.
- Time-adjusted. Assets are worth less if they must be liquidated in the short term, and worth more if the seller can maximize the sale price over the long term. Thus, evaluate assets based on their long-term liquidation value, rather than their immediate "fire sale" prices.
- Going concern concept. If a business is assumed to be a going concern over the long term, its assets are worth more, because it is using them to generate more business.
- Bankruptcy concept. If a business is in bankruptcy proceedings, it can presumably negotiate lower repayment amounts on all outstanding liabilities, and may be able to terminate some contracts that would otherwise result in the generation of additional liabilities over time. However, bankruptcy nearly always eliminates all equity, so there is no residual book value for investors to be paid.
The book value of equity concept is rarely used as a measurement within a business. Its most common application is by investors on a per share basis when evaluating the price at which a publicly-held company's stock sells.