What is Asset-Based Valuation?

The method is an effective way to determine the price demandable while selling a company. In addition, it helps analyze the cost of recreating a similar business or replacing all assets per the current market environment. Hence, clear information about the business’s worth helps the owner confidently make deals and offerings.

Key Takeaways

  • An asset-based valuation approach determines the fair market value of all assets to determine the current worth of the firm. The method is important because assets are an important factor in the revenue generation process.The common valuation methods are asset accumulation and the excess earning valuation method.The pros of the method are flexibility, simplicity of the formulas used, the inclusion of off-balance-sheet items, etc.The cons are complexity in valuing intangible assets, disregarding earnings in the calculation, assets do not necessarily point to the profitability of an entity, etc.

Asset-Based Valuation Explained

Asset-based valuation model derives the value of a company by determining the fair market value of its assets. Assets are an important factor in revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more generation. Every company with active business and operations has a set of assets and liabilities. Assets can be tangibles like property, plant & equipment (PPE) or intangibles like copyrights and trademarks.

The basic concept implies that the value of the total company equity is equivalent to the value of the total company assets (tangible and intangible) minus the value of the total company liabilities (recorded and contingent). An analyst can use different techniques to value an asset. For example, they can follow balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more values, replacement values, or fair market values.

It is a generally accepted business valuation methodValuation MethodDiscounted cash flow, comparable company analysis, comparable transaction comps, asset valuation, and sum of parts are the five methods for valuing a company.read more. The method is flexible and complex at the same time. The provision to add off-balance-sheet itemsOff-balance-sheet ItemsOff-balance sheet items are those assets that are not directly owned by the business and therefore do not appear in the basic format of the balance sheet. However, they tend to impact the financials of the company indirectly.read more like contingent assetsContingent AssetsA contingent asset is a potential and possible asset of the company in the future based on any contingent event beyond the company’s control. It will be recorded in the balance only if it becomes certain that the economic benefit will flow to the company.read more or liabilities explains its flexibility. The market worth of tangible assets is easily estimated using book value. However, estimating the value of intangible assets makes the method complex. As a result, this method may necessitate more data, analyst effort, and associated expenditures than alternative valuation approaches.

Asset-Based Valuation Methods

Let’s discuss two famous methods of valuation: the asset accumulation method and the excess earning valuation method.

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#1 – Asset Accumulation Valuation

The asset accumulation valuations methods resemble the balance sheet equation; that is, the difference between the value of assets and liabilities gives the company’s equity value or net worth. The method considers all the assets and liabilities, even the items not present on the balance sheet. For example, it includes the values of intangible assets like trademarks and contingent liabilities, which usually appear in the footnotes to the financial statements.

#2 – Excess Earnings Valuation

Excess earnings valuation method recommended by IRS Rev. Rul. 68–609 combines asset-based and income-based models aggregating asset and income information. The IRS ruling also states that the technique “should not be used if there is better evidence available from which the value of intangibles can be determined.” The method uses two capitalization ratesCapitalization RatesCapitalization Rate is the rate that helps determining value of a real estate investment. It projects the expected rate of return on the investment made. read more to identify tangible vs. intangible assets returns. So, a combination of the tangible and intangible asset values contributes to evaluating the company’s overall value. 

Various studies suggest that the excess earnings method is a feasible valuation alternative for privately held firms, lacking analyst monitoring. The difficulty in estimating two capitalization rates, on the other hand, acts as a disincentive to broader usage in business valuation.

Examples

To find the value using an asset-based approach, an analyst start this valuation procedure with an audited balance sheet. All entity assets and liability accounts are subject to revaluation to the valuation assignment standard of value. To prepare a revalued balance sheet, the analyst identifies and capitalizes all of the entity’s assets and liabilities. This process includes all of the assets and liabilities that are already recorded on the entity’s balance sheet and not recorded on the entity’s balance sheet.

Based on the values in the revalued balance sheet in line with the fair market value:

  • Total assets: $107 billionTotal liabilities: $60 billionValue: Total assets – Total liabilities = $107 – $60 = $47 billion

Consider another asset-based valuation example where the book value of assets is $50,000 (current assets, fixed assets, and other assets like investment in subsidiaries); the corresponding total derived after adding the fair market value of each item in the asset list is $76,000. The fair market value of intangible assets is $10,000. So, the value of the total assetsTotal AssetsTotal Assets is the sum of a company’s current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more is $86,000. The book valueBook ValueThe book value formula determines the net asset value receivable by the common shareholders if the company dissolves. It is calculated by deducting the preferred stocks and total liabilities from the total assets of the company.read more or fair market value of current and long-term liabilities is $33,000. In the next step, add $7,000 as the value of contingent liabilities; the total liabilities are $40,000. Finally, the total owner’s equityOwner’s EquityOwner’s Equity is the amount of money belonging to the business owners after deducting all the liabilities. The examples include Retained Earnings, Accumulated Profits, Common Stock & Preferred Stock, General Reserves & other Reserves etc. read more is derived by deducting liabilities from assets, $46,000.

Pros and Cons

Pros

  • It is the most preferred method in a critical context like liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more and M&A.It follows simple mathematical formulas.Consider off-balance-sheet items.

Cons

  • Having innumerable assets does not point to the profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more of the business.Valuing the intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can’t touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more requires attention to detail and making the overall process complex.The method does not include the earnings of the company.Requires revaluation to derive the fair market value.

This is a Guide to the Asset-Based Valuation Model. We discuss the approach using its different methods, formula, and pros & cons. You may also have a look at the following articles to learn more –

The common business valuation methods are income-based, asset-based, and market-based methods. Firstly, an example of an asset approach is the adjusted net asset method. Capitalized earnings and discounted cash flows are income approaches. Finally, merger and acquisition is an example of a market approach.

Simply, it reflects the balance sheet equation. The method determines a company’s net assets or net worth by removing liabilities from assets value. The technique is frequently used to assess a company’s net asset value based on the fair market value of its assets and liabilities. Furthermore, it includes the off-balance sheet items in the calculation.

Apart from the fair market value concept, the asset value is equivalent to the company’s book value or shareholders’ equity. The basic calculation includes deducting all total liabilities from total assets. The value of total assets and liabilities differ from what is denoted in the balance sheet due to the period considered for assessment and market value examination.

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