Market Value, Book Value, Mark-to-Model

Valuation

Explained:

Such tasks as accounting, risk management and business planning require that some or all of a business's assets (or liabilities) be valued. How to actually assign a dollar value to something is a problem as old as accounting itself. There are two basic approaches:

An asset's book value is generally its acquisition cost less depreciation. A depreciation schedule is established at the time the asset is acquired. For example, if a piece of machinery were acquired for USD 100,000, it might be depreciated over 10 years at a rate of USD 10,000 per year. At the end of seven years, the machine's book value would be USD 30,000. Assets, such as land or precious metals, which do not wear out over time, are not depreciated. Their book value is typically just their acquisition cost.

An asset's market value is the price it would fetch in the market, if it were sold immediately. Consider the same piece of machinery. Perhaps, after seven years, new technology has made it obsolete. It runs sporadically, and maintenance is expensive. At best, the company could raise USD 1,000 by selling it to a scrap metal dealer. In this case, the machine's market value is USD 1,000.

A strength of book valuation is the fact that it is formula-driven. Because accounting authorities specify detailed rules for calculating book values, there is usually little ambiguity in how assets should be assigned book values. Another strength of book valuation is its wide applicability. Traditionally, almost any asset could be assigned a book value. In recent years, this strength has been eroded. Financial innovation has introduced various derivatives or other financial instruments for which book valuation can be almost meaningless and—even worse—easily manipulated.

Another shortcoming of book valuation is the fact that the formula-driven approach can have little to do with economic reality. Suppose a firm acquires 1,000 ounces of gold at a price of USD 300 per ounce. A year later, gold is trading at USD 200 per ounce. If the firm used market value accounting, it will immediately report a USD 100,000 loss to shareholders. With book value accounting, it continues to value the gold at USD 300 per ounce. Only if it sells the gold will the firm report a book value loss to its shareholders.

Market value accounting also has shortcomings. One problem is the fact that market values represent values realized in recent transactions, but there is no guarantee that future transactions will realize similar values. Consider an example:

For years, the holdings of the US Gold Depository at Fort Knox have remained steady at 147.3 million ounces of gold held at a book value of USD 42.22 per ounce. That is a total book value of USD 6.22 billion. Suppose today's market price of gold is USD 300 per ounce. Then that same gold has a market value of USD 44.20 billion, but this is misleading. The United States government can't immediately sell the gold for that price. If it tried, the market price of gold would plummet. The government would receive only a fraction of the calculated market value.

This example is extreme, but the problem is common. An asset will be trading in small quantities at certain prices. A firm with a large position in that asset won't know what value it will fetch in the market until it actually tries to unload the position.

Market valuation works best with assets that are actively traded in liquid markets. It becomes somewhat subjective if markets have limited liquidity—some assumptions must be made to assign a market value to a stock or bond that trades infrequently. Even worse, many assets do not trade in active markets. For certain real estate, intellectual property or artwork, market value is a meaningless concept. The only time those assets can be assigned a market value is when they actually are sold.

The process of calculating a market value for an asset is called marking-to-market. For less actively traded assets, this process can be highly subjective. Models may be used to project what market values might be, assuming an active market did exist. Reliance on such models has been disparagingly referred to as marking-to-model. During the late 1990s and early 2000s, Enron Corporation used mark-to-model valuation extensively as a means of manipulating its financial reporting.

Of course, book value accounting is also subject to manipulation. A firm can "manufacture" book value earnings by selectively selling assets whose market values exceed their book values while continuing to hold assets whose market values are less than their book values. Such selective realization of gains is called gains trading. It is frequently done by corporations that want to boost their reported earnings. The reverse strategy—selectively realizing losses—can be used to reduce a corporation's taxes.

Traditionally, accounting has been based on book valuation. This can be ascribed to the historically general applicability of that approach. Even today, book valuation is the norm. An exception is financial institutions. Some can use market values for certain of their assets and liabilities. For example, a brokerage firm may carry its computers and office furniture at book value, but its securities holdings will be carried at market value. Under the Basel Accords, banks can identify a portion of their balance sheet as a trading book. Financial assets or liabilities in the trading book are carried at market value. However, most of a bank's financial assets—including its loans and any financial instruments hedging those loans—are carried at book value.

Because accounting is largely based on book valuation, it may fail to recognize deterioration in a firm's financial condition that would be reflected in market valuations. It is this problem that largely motivated the adoption of asset-liability management techniques by financial firms in the 1980s.