Book value is a measure of the net worth of a company, so it may come as a surprise that Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) trades for a premium of roughly 50% to its book value. However, if you understand what book value is and its shortcomings, this discrepancy makes perfect sense. With that in mind, here's the reason why Berkshire is worth more than its book value would lead you to believe.

What is book value?

Also referred to as a company's net worth, book value can be easily calculated from a company's balance sheet. Book value is the total value of the company's assets minus its outstanding liabilities. Dividing the book value by the number of outstanding shares of stock gives the book value per share, which investors often use to compare with the company's share price, known as the price-to-book ratio.

Warren Buffett at Berkshire Hathaway annual meeting, talking with reporters.

Image Source: The Motley Fool.

Theoretically, book value is the amount of money a company would be left with if it closed its doors, sold all of its assets, and paid off all of its debts. Admittedly, book value isn't perfect -- some of the items on a balance sheet aren't a perfect reflection of asset values, such as depreciation deductions. And many intangible items are difficult, or impossible, to accurately value.

It's not uncommon for companies to be worth more than book value

Book value is a commonly used metric in value investing, as it tends to give a baseline value of what a company is "worth." For example, if you can buy a company's stock for 80% of its book value, it can be a smart value play.

However, a company's profitability and future potential also factor into share price, so it's not uncommon for stocks to trade for significantly higher than book value. Wells Fargo, for instance, has historically been one of the most efficient and profitable banks, so it trades for 1.46 times its book value as of this writing.

In addition, book value doesn't accurately reflect certain types of intangible assets, such as intellectual property. Therefore, businesses that rely heavily on intellectual property to make products often trade for several times book value, and may still be attractive investments. I consider Apple to be an extremely cheap stock by most valuation methods, but the company trades for about 6.3 times its book value, precisely because of the shortcomings of the book value calculation method.

Berkshire's book value, and why the company is worth more

As of the end of 2016, Berkshire's book value per share (Class A shares) was $172,108, while the stock trades for $265,800 as I write this, a premium of roughly 54%. The easy explanation is that the difference is the result of Berkshire's business model that focuses on acquiring entire companies.

Here's the (slightly) longer version. Until the 1990s, Berkshire's book value and its stock price were roughly the same. This was because Berkshire's primary focus was investing in marketable securities (stocks), which are regularly revalued when included in the company's book value.

On the other hand, accounting rules for owned businesses are much different. As CEO Warren Buffett explained in his most recent letter to shareholders: "The accounting for businesses we own requires that the carrying value of 'losers' be written down when their failures become apparent. 'Winners,' conversely, are never revalued upwards."

In other words, Berkshire's book value takes a hit whenever it discovers it has overpaid for a company. However, when it becomes apparent that Berkshire has underpaid for a business, its book value doesn't get adjusted higher. Over time, this has produced a significant discrepancy between the company's share price and book value.

It's also worth mentioning that Berkshire's book value and its stock price don't always move in the same direction, or with similar magnitude. For example, in 2016, Berkshire's book value increased by 10.7% while its stock price increased by more than double this rate. Conversely, Berkshire's book value grew by 6.4% in 2015, but its stock price actually fell by 12.5%.

Over time, Berkshire's stock price has increased faster than its book value, which makes sense, given the explanation of why Berkshire is worth more than book. Over the 52-year period from 1965 through the end of 2016, Berkshire's book value has increased at an annualized rate of 19%, while its stock price has risen at an even more impressive rate of 20.8%.

Matthew Frankel owns shares of Apple and Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Apple and Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.