If you’re interested in the world of finance and business valuations, you may have periodically heard the term “asset approach”. The following article breaks down what it means and will expand your knowledge on this interesting topic.
Using an Asset Approach to Value a Company
It’s understandable if you have no idea how much your company is worth. While you may have a rough estimate, it’s a good idea to find out something more specific, especially if you’re searching for an investment, exit planning, getting a loan, or looking for due diligence on a potential purchase. Even small businesses that are hesitant to spend the money and get a company valuation done will find it beneficial in the short and long run.
You can gather a preliminary idea/baseline of what your company is worth right now by using an asset approach (which is one of three valuation approaches). You may value your company in a variety of ways, but the asset approach is a simple and accessible method to initiate your valuation analysis.
What is Asset Approach?
The asset approach, also known as the asset-based approach or cost approach, is based on the idea that the entire equity value of a company equals to:
- the difference between the value of the subject business’ assets
- the overall liability value of the subject company
The Asset Approach determines the worth of a firm by subtracting the current market value of the liabilities from the current market value of its assets. Valuation specialists will identify which of the company’s assets and liabilities should be examined and how to quantify them as part of the analysis. This might not be easy, depending on the size of the firm and several other factors. Identifying the assets to be assessed necessitates a perspective that extends beyond the balance sheet. Certain business variables, such as intangible assets such as work force or unique business procedures, are often overlooked as assets by organizations, although they can significantly influence the company’s worth.
The following are some of the most frequent valuation methods within the asset approach; the selection of the right method will depend on the characteristics of the balance sheet and the premise of value to be used (going concern or liquidation value):
Book Value Method: this method simply calculates the book value, (book value meaning the value of the asset/liability that is stated on the company’s balance sheet) which is an accounting-based value that is calculated by subtracting the book value of total liabilities from the book value of total assets. This method has two implicit assumptions: 1) the underlying assets are the main driving factor in the valuation of a company (not it’s income/revenue), and 2) the fair market value is approximated by the book value (i.e., no adjustments necessary; the car valued at 50K is actually 50K in value).
Adjusted Net Asset Value: the determination of value begins with the company’s reported financial statements. However, adjustments are made, as necessary or appropriate, to reflect the market values of the company’s assets and liabilities as opposed to their book values. The objective is to arrive at a net asset value, which is defined as the difference between the adjusted valuation of all assets and the adjusted valuation of all liabilities. Net asset value should reflect the valuation of assets and liabilities in the context of a going concern (expected to continue operating). Therefore, net asset value is not the company’s liquidation value (orderly or otherwise) because liquidation value assumes that the business is not a going concern.
Orderly Liquidation Value: this method is more appropriate for companies in the liquidation process (not going concern), and as such it is not considered appropriate for valuing operating entities. If the company is being liquidated or the ownership interest being valued has the ability to liquidate the company and receive a higher return on investment from the liquidation, this method may be the company’s best indication of value. It determines the value by adjusting the reported book values of the company’s individual assets to their actual or estimated fair market values as if they were to be sold in an orderly, piecemeal manner and subtracting the associated liabilities adjusted to their actual or estimated fair market liquidation value.
Importance of Asset Approach in a Business Valuation
When dealing with liquidation concerns, many organizations use the asset approach.
Given that “internally-developed” assets are not listed on the balance sheet, valuing intangible assets (such as the know-how, well-functioning workforce, loyal clients, patents, etc.) using this technique might be difficult. As a result, the valuation of a firm requires far more than science. The asset approach on a business valuation requires expertise, experience, attention to detail, and accuracy to use valuation techniques within valuation techniques, depending on the type of asset.
Asset-based valuations employ estimates of the market or fair value of a company’s assets and liabilities. They are thus best suited to businesses with a large mix of tangible assets and liabilities and few/insignificant intangible assets. Asset-based valuations are typically employed in conjunction with other techniques to value private enterprises.
Not all businesses have assets with clearly determined fair values, and market prices might range dramatically from carrying values (book values). Furthermore, in several economic contexts (such as hyperinflationary economies), asset values may be of little significance.
Difference Between Asset Approach and Cash Flow Approach
Which is more beneficial to stockholders—liquidating its assets or continuing to operate it as a going concern? The answer comes in comparing a) the business’ worth based on predicted cash flows discounted to reflect risk, and b) the estimated net proceeds that may be generated by selling the underlying assets and paying off all liabilities.
Cash flow approaches are the most often utilized in company valuation because of their ability to depict the future economic advantages of an ongoing firm. Applying a multiple to an income statistic like EBITDA, capitalizing cash flows, and discounting cash flows are all techniques to assess value based on cash flow, each with its own set of benefits and drawbacks.
In relation to point b) above, asset approaches are also useful for businesses in which the asset itself (not the cash flows) is the driving factor of value for the company. For example, with a real estate holding firm, the real estate is driving the value of the company. It could be used for development, capital appreciation, and also income via rent, but the value is derived from the asset, as it doesn’t produce income or it is significantly higher than the rental income.