Valuation Methods – The Asset Approach

The asset approach is one of the three approaches (along with the market approach and income approach) used to estimate enterprise and equity value, and is used in IRC 409A valuations.  The asset approach is defined in the International Glossary of Business Valuation Terms as “a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities.”  The approach uses the books of the company to identify the fair value of the assets, both tangible and intangible, and the liabilities to determine a net value for the company.  Whereas the market and income approaches both focus on income statement activity, the asset approach primarily utilizes the company’s balance sheet.  The asset approach is often utilized when a company is no longer operating as a going concern and is preparing for liquidation.  Other times the asset approach can be used is when the business is based on assets, such as an investment vehicle, and not on income, such as a production company.

Steps in employing the asset approach are:

1)     Start with the balance sheet – ideally this will be “as of” the same date as the valuation date
2)     Restate assets and liabilities to fair market value where necessary – this can be the most judgmental step in the asset approach
3)     Identify unrecorded assets and liabilities and what their impact will be on the valuation – these may be off-balance sheet commitments or assets that are not on the balance sheet

Most of the items on the balance sheet are valued in a very straightforward nature.  Cash is cash.  Marketable securities can also be as easy as cash to value due to a stated market value.  Accounts Receivables and Prepaid Expenses typically have a fairly easy valuation.  Property, Plant & Equipment (“PPE”) and Inventory of a company can be more difficult to value.  These categories of assets should be considered carefully and valued appropriately.

There are times when a third party may be used to value certain elements of the balance sheet.  PPE is a good example of this.  For example, most valuation specialists are not specialists at valuing land and many companies may own land.  The same can be true for a machine used in production.  A company may have purchased the machine for one price and depreciated it to another.  However, the value of the machine may different from either of these values based on what it could be sold for on the open market.

Liabilities can also provide similar judgmental decisions for a valuation specialist.  While accounts payable and many accrued expenses are straightforward in their value due to a specific amount stated on an invoice, a liability such as a warranty accrual or a litigation accrual can be far less clear in its fair value and what it should be carried at during a valuation.  Significant consideration should be given to these more opaque items on the balance sheet when performing the valuation.

A last item where judgment may come in to play is with intangible assets, such as trademarks.  Self-created intangibles are not put on the balance sheet of a company and therefore do not automatically require valuing and adding to the balance sheet.  However, intangibles added through acquisition or purchase may exist and the skills of the valuation specialist need to be considered in whether or not to utilize a third party to value the intangibles.

The simplest way of thinking about the asset approach is:

Assets – Liabilities = Asset Approach Value

This also equals “Equity” on the balance sheet.  This is a very rough view but still a way in which someone could begin to gauge the value of a company through the asset approach before beginning a deeper look into each of the line items of the balance sheet.
Considerations that need to be made when using the asset approach are:

–        Premise of Value
–        Control
–        Marketability
–        Asset or Income based business
–        Going concern

The asset approach, whether ultimately relied upon or not, is important for a valuation specialist to consider in a 409A valuation.  Although used less often for operating companies which derive value from their income statement, an experienced valuation professional will still consider the impact a company’s assets will have on the value of that company, whether for 409A valuation purposes or otherwise.

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