The Term ‘Value’ Explained in Terms of Accounting, Economics and Finance

What is value?

In accounting and finance, the term ‘value’ is associated with numerous concepts, referring to the monetary, material, or assessed worth of, inter alia, an asset, business entity, goods purchased, sold, or exchanged, services provided, or liability or obligation acquired.

Corporate Finance Institute describes value in economics as ‘the sum of all benefits and rights arising from ownership.’

This article intends to explain the basics of the following concepts in accounting, finance, and economics in which the term value plays a prominent role:

• Book value
• Book value per share (BVPS)
• Carrying value
• Collateral value
• Depreciated value
• Economic value
• Fair value
• Enterprise value
• Going concern value
• Intrinsic value
• Investment value
• Liquidation value
• Market value
• Net asset value (NAV)
• Replacement value
• Salvage value

What is book value?

Book value is an accurate indication of a company’s worth as reported on its balance sheet. In other words, book value is simply what a company’s balance sheet says a company is worth.

The formula to calculate book value is:

Book value (shareholders’ equity + Retained earnings) = Total assets – Intangible assets – Total liabilities

Where:

• Total assets = Current assets + non-current assets, also called long-term assets.
• Intangible assets comprise assets like trademarks, patents, and goodwill.
• Total liabilities = Current liabilities + non-current liabilities also referred to as long-term liabilities.

An asset is reported on the balance sheet at its historical (original) cost less accumulated depreciation.

Book value can also be described as the net asset value (NAV) of a company.

It is also a value that represents the total amount of money remaining in a company if the company sold off all its assets and paid off all its debt obligations and liabilities.

Other features of book value are:

• It is not typically a subjective figure because historical data is used.
• Enables analysts and investors to obtain a reasonable picture of a company’s worth.
• Book value is often below the market value of an asset or company. Hence, a company’s book value can be compared to its market value, indicating whether the shares of a company are over or underpriced.

The fact that intangible assets, such as goodwill and intellectual property, are not included in book value, is considered a shortcoming in the calculation of a company’s book value.

Regarding the personal finance of investors, the book value of an investment is the amount paid for a security or debt investment like a government or corporate bond.

What is book value per share (BVPS)?

Book value per share (BVPS) is a ratio used by investors and analysts to evaluate a company’s share price. If the BVPS exceeds the market value per share, the company’s shares are considered undervalued. Contrarily, if the BVPS is less than the price of a share on a stock exchange, it is an indication that the shares are overvalued.

BVPS also referred to as the ratio of equity, is a ratio that measures the total equity of ordinary shareholders against the number of shares outstanding, which refers to all the shares issued by a company.

Put differently, it is a ratio that measures a company’s book value on a per-share basis.

BVPS is calculated as follows:

BVPS = (Shareholders’ equity – Preference shares)/Average ordinary shares outstanding

Where:

• Preference shares are excluded from the calculation because they are rated higher than ordinary shares during the liquidation of a company.
• Average shares outstanding can be calculated using one of the following two methods:

A comprehensive method: Assuming company ABC has 120 000 shares outstanding in April, issues 50 000 shares in May and another 20 000 shares in June. Hence, the outstanding shares in the different months were as follows:

• April: 120 000 shares
• May: 170 000 shares (120 000 shares + 50 000 shares)
• June: 190 000 shares (170 000 shares + 20 000 shares)

The three months are aggregated to obtain a sum of 480 000 shares (120 000 shares + 170 000 shares + 190000 shares). The sum is then divided by the number of months (3) involved in the measurement period to obtain an average outstanding figure of 160 000 shares.

Simple average method: Using a simple average method, the opening and the closing balance of the shares are added together and divided by 2. The average shares outstanding of company ABC will then be calculated as follows:

Average outstanding shares = (Opening balance in April + Closing balance in June)/2

= (120 000 shares + 190 000 shares)/2

= 310 000 shares/2

= 155 000 shares

Noteworthy, the number of average outstanding shares according to the comprehensive method is 5 000 shares more than the simple average method’s total.

Example of BVPS

Company Well Away has R5 million of shareholders’ equity which includes R1 million of preference shares. The total of the company’s average outstanding ordinary shares is two million.

The company’s BVPS will be calculated as follows:

BVPS = (R5 000 000 – R1 000 000)/2 000 000

= R4 000 000/2 000 000

= R2

Ways to increase the BVPS of a company:

• Reacquiring ordinary shares

Repurchasing ordinary shares is one of the most preferable methods used by a company to increase its BVPS.

• Increase assets and decrease liabilities

A company can use the profits it generates to either increase its assets or reduce its debt obligations or other liabilities.

What is carrying value?

Carrying value, also called carrying amount, refers to the original (historical) cost of an asset as reported in a company’s accounting system and on its balance sheet minus any factors that diminish the original cost. Based on the nature of the asset, diminishing factors are:

• Accumulated depreciation for physical assets. (However, the land is not depreciable as an asset.)
• Accumulated amortisation regarding intangible assets.
• Impairments, when an asset’s fair value drops below its carrying value.

In accounting, the terms book value and carrying value are used interchangeably.

What is collateral value?

Collateral value is the total fair market value of an asset or assets to secure a loan that is provided by a lender to a borrower. Typically, the fair market value is determined through an official appraisal process.

A loan covered by collateral is called a secured loan, reducing the risk to the lender.

An example of an asset that can serve as collateral for a loan is a house, used as collateral for a home mortgage. Other assets with collateral value are vehicles, inventory, or cash.

If a borrower defaults on a loan, meaning stop repayments on the loan, a lender has the right to seize the asset used as collateral and sell it to recover the outstanding money on the loan.

The size of a secured loan in relation to its collateral value is referred to as the loan-to-value (LTV) ratio. For instance, a bank lends R1 000 000 to a business in order to by equipment with a collateral value of R1 300 000. The LTV ratio will be calculated as 77% – (R1 000 000/R1 300 000) x 100.

What is depreciated value?

Depreciated value refers to the value of a fixed asset after the total amount of the depreciation expenditure allocated to it, known as the accumulated depreciation, has been taken into consideration.

A depreciable asset will decrease in value each year as it ages. Hence, a new depreciated value of an asset is calculated each financial year.

In accounting, depreciation refers to the method used by companies to allocate the cost of a physical asset over its useful life, also referred to as its life expectancy.

International Accounting Standard 16 describes depreciation as the allocation of an asset’s depreciable amount on a systematic basis over the useful life of the asset.

There are numerous formulas to calculate the depreciation expenditure of a fixed asset. The most common method used is the straight-line method.

In South Africa, the South African Revenue Service (SARS) refers to depreciation expenditures as ‘depreciation allowances, or ‘wear-and-tear allowances.’

SARS allows businesses to allocate a fixed asset’s depreciation expenditure in accordance with one of two methods, namely the straight-line method or the diminishing value method.

(See the article, ‘Depreciation in Accounting Explained for Dummies,’ for a detailed explanation of depreciation.)

What is economic value?

Simply put, economic value refers to the maximum amount of money a person is willing to pay for a service or good, based on the benefit he or she gains from it and considering how the amount of money could be spent elsewhere.

Economic value is based on the choices and preferences of individuals.

For instance, if a person has only the choice between a slab of chocolate and a bag of apples, the value of the apples would be measured by the most chocolate the person is willing to forgo to have more bags of apples.

The following example is another way to explain economic value: Let us say a customer has a choice between a kilogram of cheese and a tin of coffee, which both sell for R80. Because the customer prefers cheese, he or she is willing to pay up to R100 per kilogram for the cheese and would only pay R90 at the most for the tin of coffee. Hence, the net economic benefit the customer receives for the cheese is R20, and for the coffee only R10.

Economic value is difficult and sometimes almost impossible to determine because its calculation is based on subjectivity. Hence, economic value is most of the time an estimate.

What is fair value?

Fair value refers to the sale price of a product, asset, or security that is agreed upon by a willing buyer and seller, assuming that both parties are knowledgeable about the transaction, and enter the transaction at will.

International Financial Reporting Standard (IFRS) 13 defines fair value as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’

The definition of IFRS 13 is based on the concept of an ‘exit price’ which is described as ‘the price that would be received to sell an asset or paid to transfer a liability.’

Corporate Finance Institute mentions that ‘fair value is applicable to a product that is sold or traded in the market where it belongs or under normal conditions.’

Fair value differs from market value in, inter alia, the following ways:

• Market value fluctuates more than fair value.
• Fair value refers to the intrinsic worth of a product, asset, or security, while market value refers solely to the price of a product, asset, or security in the market where it is bought and sold, as determined by the law of supply and demand.

What is enterprise value (EV)?

Enterprise value (EV) is an indication of the total value of a company, representing the entire market value rather than just the equity value.

The enterprise value of a company indicates how efficiently a company is managed.

There are two formulas to calculate EV:

• Simple formula

EV = Market capitalisation + Market value of debt – Cash and Cash equivalents

• Extended formula

EV = Ordinary shares + Preference shares + Market value of debt + Minority interest – Cash and Cash equivalents

Concepts of enterprise value:

• Market capitalisation

Market capitalisation, commonly called a market cap, is the number of outstanding shares of a company multiplied by the current market price of its shares.

• The market value of debt

The market value of debt refers to credit provided by lenders and creditors. The debt liabilities are interest-bearing liabilities, comprising short-term and long-term debt. If the debt’s market value cannot be determined, the book value of debt can be used instead.

Some analysts deduct cash from the debt, assuming that when a company has been acquired, the acquiring company can use the acquired company’s cash to pay a part of the debt.

• Minority interest

Minority interest, also called non-controlling interest (NCI), indicates ownership of less than 50% in a company.

• Cash and Cash Equivalents

This is the most liquid asset of a company. Cash equivalents comprise, inter alia, marketable securities and money market funds.

The amount of cash and cash equivalents is deducted from EV because it is considered that it will reduce the acquiring cost of the acquired company. However, not all analysts deduct cash and cash equivalents from EV.

What is going concern value?

Going concern value, also known as a total value, refers to the ability of a business to indefinitely carry on as a business and continue to be profitable and to generate positive cash flows.

The going concern value differs from a company’s liquidation value because it includes tangible assets such as goodwill, as well as any potential for future revenue. Hence, the going concern value is typically much higher than a company’s liquidation value.

What is intrinsic value?

Intrinsic value is only interested in the inherent value of a business, investment, or asset.

Corporate Finance Institute (CFI) describes the intrinsic value of a business or any investment security as ‘the present value of all expected future cash flows, discounted at the appropriate discount rate.’

CFI also provides a very simple definition of intrinsic value: ‘The price a rational investor is willing to pay for an investment, given its level of risk.’

One of the commonly used methods to calculate a company’s intrinsic value is the discounted cash flow (DCF) method in which a company’s free cash flow and the weighted average cost of capital (WACC) are used.

WACC takes the time value of money into consideration and then discounts all the future cash flow to its present value.

What is investment value?

Investment value refers to the amount of money an investor would pay for an asset, such as a property.

Investment value is unique to each investor because it is based on the investor’s personal objectives, the valuation method used to determine the value of an asset, and a variety of assumptions such as financing capabilities, expected return, estimates of cash flow, and tax rates, to name a few.

What is liquidation value?

Liquidation value refers to the total worth of a business’s physical assets, also called tangible assets, if it goes bankrupt and the tangible assets are sold quickly, usually at a much lower price than the original price.

The expected liquidation value of a business is calculated by deducting the business’s liabilities from its assets. However, intangible assets like goodwill, intellectual property, and trademarks are not included in the calculation of the liquidation value.

What is market value?

Market value is an indication of how much security or asset is worth in a financial market. It also represents the value of a company according to investors and traders in a stock exchange.

Regarding a public traded company, market valuation is also referred to as market capitalisation, determined by calculating the number of outstanding shares with the current share price of the company.

With regard to a private company, it is simply the highest value a prospective buyer would pay to acquire the company.

Market value ratios are used by investors and analysts to determine the current share price of a public traded company. Market value ratios comprise, inter alia, the following ratios:

• Book value per share (BVPS) ratio

See ‘What is book value per share (BVPS)?’ in the article.

• Earnings per share (EPS) ratio

The EPS ratio is calculated by allocating a company’s net profit to each outstanding ordinary share.

The formula to calculate the EPS ratio is:

EPS = Net income/Average outstanding ordinary shares

• Price-earnings (P/E) ratio

The P/E ratio is calculated by dividing the current price of a company’s shares by the earnings per share.

• Market/Book ratio

The market/book ratio compares a company’s market value to its book value. It is calculated by dividing the market value per share by the book value per share (BVPS). (Market value per share is obtained by dividing a company’s market value by its total number of outstanding shares.)

What is net asset value (NAV)?

Net asset value (NAV) refers to either:

• The context of a company

In this regard, NAV is calculated by deducting a company’s total liabilities from its total assets.

Or,

• The context of a mutual fund or exchange-traded fund (ETF)

In this context, the NAV indicates the per share/unit price of the particular fund on a specific date.

What is replacement value?

Replacement value, also called replacement cost, is the amount of money an entity would pay to replace an essential existing asset with a similar asset or one that has the same functions as the original asset at current market prices.

The replacement value of an asset may vary from the asset’s market value.

What is salvage value?

Salvage value also called scrap value or residual value, is the estimated book value of an asset at the end of its useful life.

Put differently, salvage value is an asset’s book value after all the depreciation expenditure has been fully taken into consideration.

A responsible estimation of salvage value is important because a too low or too high salvage value has, inter alia, the following consequences for a company.

In addition, the debt-to-equity ratio would be lower, causing difficulties to secure future financing for the company.