Valuation Basics: Understanding the Asset Approach
The business valuation process determines the current market value (CMV) of a company. It entails in-depth qualitative and quantitative analysis of all factors impacting a business.
There are three primary valuation approaches: the asset approach, the market approach, and the income approach. These approaches calculate a business value in different ways, but all strive to determine an accurate value for a company. Analysts usually use one or a combination of methods to determine business value.
This article focuses on the asset approach to calculate business value.
The Asset Approach
The asset approach of business valuation determines value using the companyâ€™s balance sheet as of the valuation date. It uses the fundamental equation associated with the balance sheet: Assets = Liabilities – Equity.
There are two basic methods used in this approach to calculate business value:
- The book value of equity method
- The adjusted book value of equity method.
The Book Value of Equity
The straightforward book value of equity method determines business value using the equity on the company’s balance sheet. However, analysts do not use this method frequently because it does not consider two key factors:
- The fair market value of the assets and liabilities of the company is under review.
- The company’s ability to generate profit from its assets.
Omission of these key factors may result in significant undervaluation of the company.
For example, let’s consider a holding company that owns apartment complexes in a big city to understand the difference between book value and fair market value of assets. Suppose the company owns seven apartment complexes purchased in the 1990s for a million dollars each.
Assuming that the balance sheet now shows current assets of $3 million, fixed assets of $0 (as the apartment complexes are fully depreciated at cost), and no debt, the book value is $3 million. But is it possible that seven apartment complexes in a major city are worth nothing? Of course not.
Because the asset approach bases its estimates on the balance sheet, it does not consider its ability to generate profit from those assets. Therefore, it often undervalues a business as it disregards its ability to generate profit. To avoid that, analysts deploy the asset approach in situations where a significant portion of the value is attached to its fixed assets and not its ability to generate profit.
Adjusted Book Value of Equity
The adjusted book value of equity method solves the above issue by considering the fair market value of assets and unconsidered liabilities. It establishes the company’s floor value based on the business owner’s amount after selling the assets and satisfying liabilities. It does not necessitate actual liquidation of the company but determines business value based on the fair market value of its assets and liabilities.
The adjustments made by the adjusted book value of equity method include:
Inventory. This method of the asset approach makes adjustments to inventory for companies that report it on a last-in, first-out (LIFO) basis. LIFO moves out recently purchased inventory items and results in the inventory balance reporting costs incurred before the effective analysis date. It may not represent the current cost to replace inventory.
The first-in, first-out (FIFO) method of accounting better represents current market value. It is widely accepted to adjust a company’s inventory to FIFO basis. Also, consider writing off slow-moving or obsolete inventory.
Tangible assets. The book value of a company’s real property (e.g., land, land improvements, buildings, or personal property, such as machinery and equipment, furniture and fixtures, vehicles, etc.) often do not reflect fair market value. Hire the services of a professional appraiser to determine the market value of your tangible assets.
Goodwill and intangible assets. The adjusted book value of the equity method credits no value to goodwill and intangible assets. Income- or market-based valuation approaches better reflect the value of these assets.
Receivables and payables. Consider whether a receivable is fully collectible or a payable will be paid in full. Often, this is the case for related parties like intercompany receivables or loans to shareholders. Discuss relevant accounts with management and ascertain if adjustments are required for potentially uncollectible receivables or payables that may never be paid.
Unrecorded Assets or liabilities. Make adjustments for unrecorded assets or liabilities, such as potential legal settlements or judgments.
Pros and Cons of the Asset Approach
Valuators use the asset approach for companies having significant value in fixed assets or showing negative earnings. This approach helps determine the lowest possible value for the company without considering its ability to generate profits.
The asset approach is used to value a company facing liquidity issues. It helps determine the base level of value the company could be worth upon liquidation. However, it requires adjustments to calculate the assets and liabilities at their fair market values.
This approach is flexible in deciding which assets and liabilities to consider for valuation and the methods to value them. It helps determine the value of companies in the investment segment.
The asset approach is straightforward: assets minus liabilities. The process becomes complex when adjusting assets and liabilities, but the arithmetic itself is simple.
The asset approach does not consider a business’s ability to generate profit from the products or services it offers. Analysts use this method when the combined asset and income yield a lower value than the book value or adjusted book value or when the company’s value primarily depends upon its tangible assets.
The method involves measuring even those items that do not show on the balance sheet, which can be difficult. The asset approach requires analysts to have a high level of attention to detail, experience, and accuracy to determine business value. A lack of experience or proper data could lead to an inaccurate valuation.
Asset Approach Challenges
Assets in a balance sheet show value at cost less depreciation, not their fair market value; therefore, analysts need to adjust the value of those assets. A balance sheet does not show the correct value of intangible assets, if it shows them at all. Valuing intangibles like trade secrets can be challenging. Also, making adjustments to liabilities is challenging, as doing so could raise or deflate their value which impacts the calculation of business value.
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