Business Valuation: The Asset-Based Approach
Of the many approaches to calculating the value of a business, there are three main types, namely the income-based, asset-based and market-based approach.
It is normal if you don’t know the value of your business off the top of your head. While you may have a general idea of what your business is worth, its a good thing to find out, especially if you are looking for funding for your company or to complete a business deal. Even for small companies reluctant to have a business valuation done, it could prove to be useful in the end.
By having a business valuation done, you would be able to ensure that you have a thorough and clear understanding of what your business is worth at the moment. It would not just help you in making deals confidently, but would also offer you a peace of mind that your company is on the right track. And there are many ways by which you can determine your business valuation.
Asset-Based Business Valuation
Out of all the business valuation methods out there, the asset-based business valuation is the one that stands out. This is because it examines the total value of the assets in your company. The assets include tangible items in the company such as real estate and cars, as well as intangible assets like intellectual property, such as copyrights and trademarks.
The market value of some of these items, mostly tangible ones, can be easily determined with the help of the company books. But it becomes very difficult for calculating the worth of the intangible items. You will be able to calculate an asset-based valuation for a company using the help of the following two approaches:
- Going Concern: Under this approach, the business needs to list out its net balance sheet value of its assets. The value of the company’s assets less liabilities is then subtracted. It is recommended for businesses that do not plan to sell their assets or liquidate and want to stay in business for some time to use this valuation approach.
- Liquidation Value: You can guess this approach from its name. It requires a bit more urgency than its going concern counterpart. In case the business is in the process of liquidating, then it must quickly calculate its amount of net cash. This is the cash received as soon as the assets are sold and the liabilities are repaid. It tends to be less than market value due to its surrounding “everything has to go” circumstances.
Calculating Asset-Based Value
As mentioned above, the asset-based approach uses the value of the assets to calculate a business entity’s valuation. Simply put, the asset-based value is equal to the book value of the company or the equity that the shareholders hold. And the value is determined by subtracting the liabilities from the assets.
Most of the time, the value of the assets minus the liabilities can be different from the values that are reported on the balance sheet due to timing and other factors. An asset-based business valuation can offer latitude for using market values instead of the balance sheet values. The analyst can also include many intangible assets in the valuation which may or may not be on the balance sheet. But it is not that easy; the next section will explain why.
Adjusting Net Assets
One of the greatest challenges in arriving at an asset-based valuation is the adjusting of the net assets. The adjusted asset-based business valuation aims at identifying the market value of the current environment, and the balance sheet valuations use depreciation to reduce the value of the assets over time. So, the book value of an asset is not specifically equivalent to their fair market value.
There are many other considerations of asset adjustments that include certain intangibles, which are not included at all or are not completely valued on the balance sheet. A lot of companies might also not find it important to value a few trade secrets. But since the adjusted asset-based business valuation looks at what the company could potentially sell for in the market, these intangibles would be important to consider.
In the adjusted net asset calculation, the adjustments can be made for the liabilities as well. As a matter of fact, the market value adjustments can potentially increase or decrease the value of the liabilities, which directly affects the calculation of adjusted net assets.
Pros and Cons of asset-based business valuation
With all this clear, let us understand the pros and cons of an asset-based business valuation. A lot of companies utilize the adjusted asset valuation method in cases where they are experiencing issues related to liquidation. And companies that are in the investment industry, where the assets are calculated through the market approach or based on their income, can also use the asset-based business valuation method.
However great this method is for any business valuation, it does have its drawbacks. Unlike the other methods, this one disregards the company’s prospective earning potential. In fact, the business value of a company can be much higher as compared to when its existing assets are disposed of, item by item.
And since internally generated products are not available on the balance sheet, the process of measuring the intangible assets can be very complicated when performing a business valuation with this method. With this said, valuing a company needs a lot more than just science. The person who performs the asset-based business valuation needs knowledge along with experience, attention to detail and accuracy.
Asset Business Valuation Methods
Let us talk about the various methods that fall under the asset-based business valuation method.
Asset Accumulation Valuation
The first method is called the asset accumulation method, that bears a striking similarity to the widely known balance sheet. In this method, all the assets and liabilities of a company are compiled and each one is given a value. And the value of the company here is the difference between the value of its assets and liabilities. Even though this sounds very simple, the devil is in the details.
Every asset and liability has to be identified carefully. Along with this, the asset accumulation method requires an effective way of assigning values to each asset and liability. And as talked about before, a few items used during the business valuation do not always appear on the standard balance sheet. They include internally generated intangible assets such as patents, trademarks, and trade secrets. This list also includes provisional liabilities that usually include unresolved legal cases or compliance costs.
Excess Earning Valuation
The second kind of asset-based business valuation method is the excess earnings valuation. This approach is a combination of the income and the asset-based valuation method. In this method, we do not just evaluate the tangible assets and liabilities in the company; The goodwill of the business is also worked out. To be able to determine the goodwill of the company, the earnings of the businesses are treated as input and then a connection is drawn to the income method.
Due to this, the excess earnings method is highly preferred when valuing large and financially sound businesses with substantial goodwill. One of the most typical examples is businesses that provide professional services such as engineering companies, medical practices, law firms, accounting firms, and architectural firms. This method is also great for a business valuation of well-established technology companies and manufacturing enterprises.
But remember that the selling price and the value of a business are never the same. The next section will explain this better.
Business Value vs. Selling Price
The value of a business and its selling price are not the same. The reason why many businesses conduct the asset-based valuation is to get what an entity would go for in theory. Nonetheless, in reality the value of the entity varies based on the person doing the valuation. This means that an overexcited buyer who is searching to replace losses can choose to pay a substantial sum just to get a business.
Asset Accumulation valuation – Case study
Let us get a better understanding of the asset-based business valuation method by looking at an example. As mentioned above, the adjusted net asset method and the asset accumulation method are the ones most openly accepted by businesses. Keeping this in mind, let us look at an example below:
A valuation expert is retained to estimate the fair market value of the total equity of ABC company on December 31st, 2018. Let us assume that this company is a family-owned construction company. The valuation expert decided to use the asset-based valuation approach and the asset accumulation valuation method in this case.
To understand things better, below is the unadjusted balance sheet of the company along with the adjustments made by the valuation expert.
|As of December 31st, 2018|
|Assets||Book Value||Change||Fair Market Value|
|Total Current Assets||$10,000||$10,000|
|Property, Plant and Equipment|
|Land and Buildings||$30,000||$5,000||$35,000|
|Machinery and Equipment||$10,000||$10,000||$20,000|
|Net Property, Plant and Equipment||$40,000||$55,000|
|Investment in Subsidiaries||$10,000||($2,000)||$8,000|
|Internally Developed Computer Software||-||$7,000||$7,000|
|Trained and Assembled Workforce||-||$3,000||$3,000|
|Intangible Value of Goodwill||-||$2,000||$2,000|
|Liabilities and Owner’s Equity|
|Total Current Liabilities||$8,000||$8,000|
|Total Long-term liabilities||$22,000||$40,000|
|Total Owner’s Equity||$30,000||$20,000||$50,000|
|Total Liabilities and Owner’s Equity||$60,000||$90,000|
On the unadjusted balance sheet, tangible assets are recorded at historical cost less depreciation. Along with this, no internally developed intangible assets have been recorded.
That is when the valuation expert documented the asset accumulation method valuation analysis on the newly developed balance sheet as below:
Here is a detailed explanation of how the expert reached this new balance sheet:
(1) The valuation expert considered all of the company’s current accounts, and based on the analysis of the aged accounts receivable balance, the valuation expert valued this account from $4,000 to $3,000. Along with this, the valuation expert restated the inventory balance from the $5,000 last-in, first-out (“LIFO”) accounting convention to a $6,000 current replacement cost value.
(2) The valuation expert considered all of the company’s tangible personal property and real estate. For these, the expert used the cost approach and the depreciated replacement cost method to value both the real estate and the tangible personal property. Based on this, the expert estimated that the FMV of the real estate is $35,000 as compared to the historical cost less depreciation (“HCLD”) of $30,000. The value of the tangible personal property was also estimated to be $20,000 as compared to the HCLD of $10,000.
(3) The valuation expert separately valued the company’s unconsolidated ownership interest in its subsidiary. Using the guideline publicly traded company (“GPTC”) method and the market approach, the expert valued the total equity of the subsidiary at $20,000. The main company owns 40% of the subsidiary equity. With this, the expert valued the main company’s ownership interest at $8,000, which represents a decrease in value compared to the $10,000 carrying value of this investment.
(4) The expert performed a detailed due diligence analysis to identify all the company’s intangible assets. This due diligence showed that there were some intangible personal property and intangible real property including a trained and assembled workforce, customer contracts, and an internally developed computer software.
The company uses its developed software for all its project and administrative management functions. So the expert used the depreciated replacement cost method and the cost approach to get the estimated value of $7,000 FMV for this intangible asset. Moreover, the company gathered a team and trained them over the years, which also made it a valuable intangible asset. Using the same method, the expert estimated a $3,000 cost to recreate a workforce of comparable experience and expertise.
Being at any point, the company had several dozen customer construction projects in different stages of completion. For this, the expert used the multi-period excess earnings method and the income approach to get the value of the customer contacts. By working with the company management, the expert projected the remaining profit to be earned on each contract as well. The expert valued the future cash flow projection at the company’s 10% of the weighted average cost of capital (“WACC”) indicating a $5,000 FMV for this customer-related intangible asset.
The expert compared the company’s actual earnings, which is measured as EBIT to this required earnings level. And based on this, the company was generating a small amount of excess earnings. The expert then capitalized on the excess earning as an annuity in perpetuity to conclude a $2,000 FMV for the goodwill.
(5) The business valuation expert now moved to the liabilities part of the balance sheet. The expert considered the liability accounts and concluded that the recorded balance was the right FMV values of the accounts under the accounts payable and the accrued expenses.
(6) The expert then considered the mortgage payable and the notes payable. And this person then concluded that the embedded interest rates on these instruments were sufficiently close to the current market interest rates so that no liability revaluation was needed.
(7) The expert then performed some extra due diligence to get the value of any contingent liabilities in the company. And in this, several litigation claims against the company were found, which were related to the previous construction projects. So, the expert worked with the legal counsel and the company to estimate the expected future claim payment amounts which included the timing of payments and the probabilities. The value obtained was $10,000 which was then added to the balance sheet.
(8) The expert can now get the net asset value for the adjusted balance sheet. And at this point, the expert concluded the FMV of all of the total assets to be $90,000. Additionally, the expert also concluded the FMV of all of the liabilities to be $40,000. And the difference between the two value indications, that is the total asset value minus total liability value, is the fair market value of the total equity resulting in the FMV of the company’s equity is $50,000.
All in all, the asset-based business valuation method is a great method to get the exact value for which a company can be sold. And even though there are many other methods out there, the asset-based valuation method is often preferred because of its applicability in instances where a business is suffering from challenges relating to liquidity. If you want to learn more about the other methods, check out the articles here.
And while you prepare your company to get its business valuation done, remember that you will have to show them your cap table as well. If you have not yet started using Eqvista to keep a track of your shares for FREE, then it is time to do so. Check out the application here to know more!