Are You Really Going to Use Book Value?

A few years ago, I was in a meeting with an attorney from a law firm with a good reputation. Part of our meeting had to do with calculating a private company's stock value. The lawyer wanted to use the book value of the company's equity. This is the amount stated on the company's balance sheet. I tried to explain to him that book value wasn't a good way to value the equity of a privately held company. I was astonished how vigorously he defended his method. He went on to say he used this technique to sell many companies and was actually going to use it later on that day to sell a cement business.

I find it interesting to hear people refer to book value as if it were the same as market value. Some people won't start negotiations until they check the book value. So what is book value and is it really value? Book value is an accounting figure carried on the balance sheet. It is imperative to know that it's easily manipulated. The IRS allows owners to choose different types of depreciation methods which directly impact book value.

Here is an example. Let's say you buy an asset for $55,000. To keep it simple, the estimated salvage value is $5,000 and Section 179 bonus depreciation doesn't apply; therefore, the asset's total depreciable amount is $50,000. The estimated useful life is five years.

If you decide to use straight-line depreciation, the book value is decreased $10,000 each year for five years. If you decide to use an accelerated depreciation method like double declining balance, the book value is decreased $20,000 the first year and $12,000 the second. Depreciation continues to decline each year after.

If you decided to sell the asset for its book value at the beginning of the third year and you were using the straight-line method, you would sell it for $30,000. If you were using the double declining balance method, you would sell it for $18,000.

Why do some buyers and sellers use book value as their price? It's because they mistakenly assume it's equal to some kind of value. Remember, book value for an asset is the original cost minus an estimated salvage value of the asset depreciated over a time period allowed by the IRS with a depreciation method chosen by the owner. Why do some owners choose one depreciation method over another?

Owners of privately held businesses and professional practices with taxable income like to accelerate depreciation. By using this type of depreciation, they can lower their tax liability in the short term. If they don't have a significant tax liability, they will typically use the straight-line method to save the tax benefit for later years.

The book value of a company's equity is directly linked to its assets because the book value of its assets minus its debt equals the book value of its equity.

If you sell a business or professional practice for book value, your chances of it being equal to market value are slim to nothing. If you used book value and have assets that are fully depreciated (their book value is zero), you are giving those assets to the buyer for free. By using book value, you're also not taking into consideration any intangible value that may exist. This includes the value of your goodwill, customer lists, trained staff, proprietary systems, and any patents or trademarks.

You should also remember that some assets actually increase in value. Works of art, wine, and precious metals, are just a few examples of assets that can be worth more than their original purchase price.