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BOOK VALUES AND MARKET VALUES

Throughout this material we will frequently make a distinction between the book values of the assets shown in the balance sheet and their market values.

Items in the balance sheet are valued according to generally accepted accounting principles, commonly called GAAP. These state that assets must be shown in the balance sheet at their historical cost adjusted for depreciation. These book values are therefore ¬backward-looking ­ measures of value. They are based on the past cost of the asset, not its current market price or value to the firm. For example, suppose that a printing press cost McGraw-Hill $1 million 2 years ago, but that in today`s market such presses sell for $1.3 million. The book value of the press would be less than its market value and the balance sheet would understate the value of McGraw-Hill`s assets. Or consider a specialized plant that Intel develops for producing special-purpose computer chips at a cost of $100 million. The book value of the plant is $100 million less depreciation. But suppose that shortly after the plant is constructed, a new chip makes the existing one obsolete. The market value of Intel`s new plant could fall by 50 percent. In this case market value would be less than book value.

The difference between book value and market value is greater for some assets than for others. It is zero in the case of cash but potentially very large for fixed assets where the accountant starts with the initial cost of the fixed assets and then depreciates that figure according to a prespecified schedule. The purpose of depreciation is to allocate the original cost of the asset over its life, and the rules governing the depreciation of asset values do not reflect actual loss of market value. As a result, the book value of fixed assets often is much higher than the market value, but often it is less.

The same goes for the right-hand side of the balance sheet. In the case of liabilities the accountant simply records the amount of money that you have promised to pay. For short-term liabilities this figure is generally close to the market value of that promise. For example, if you owe the bank $1 million tomorrow, the accounts show a book liability of $1 million. As long as you are not bankrupt, that $1 million is also roughly the value to the bank of your promise. But now suppose that $1 million is not due to be repaid for several years. The accounts still show a liability of $1 million, but how much your debt is worth depends on what happens to interest rates. If interest rates rise after you have issued the debt, lenders may not be prepared to pay as much as $1 million for your debt; if interest rates fall, they may be prepared to pay more than $1 million.2 Thus the market value of a long-term liability may be higher or lower than the book value.

To summarize, the market values of neither assets nor liabilities will generally equal their book values. Book values are based on historical or original values. Market values measure current values of assets and liabilities.

The difference between book value and market value is likely to be greatest for shareholders` equity. The book value of equity measures the cash that shareholders have contributed in the past plus the cash that the company has retained and reinvested in the business on their behalf. But this often bears little resemblance to the total market value that investors place on the shares.

If the market price of the firm`s shares falls through the floor, don`t try telling the shareholders that the book value is satisfactory they won`t want to hear. Shareholders are concerned with the market value of their shares; market value, not book value, is the price at which they can sell their shares. Managers who wish to keep their shareholders happy will focus on market values.

We will often find it useful to think about the firm in terms of a market-value balance sheet. Like a conventional balance sheet, a market-value balance sheet lists the firm`s assets, but it records each asset at its current market value rather than at historical cost less depreciation. Similarly, each liability is shown at its market value.

The difference between the market values of assets and liabilities is the market value of the shareholders` equity claim. The stock price is simply the market value of shareholders` equity divided by the number of outstanding shares.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

Procedures for preparing financial statements.

BOOK VALUE Net worth of the firm according to the balance sheet.