Reading between the lines

The asset-based valuation approach is less complex and easier to apply

The asset-based approach to valuation focuses on a company's net asset value (NAV), or the fair market value of its total assets minus its total liabilities, to determine what it would cost to recreate the business. While there is some room for interpretation in terms of deciding which of the company's assets and liabilities to include in the valuation, an asset-based valuation approach is generally the easiest to apply relative to the traditional income-based and market approaches.

As an illustrative example, if we consider Company A, a pipe manufacturing business that has been operating for 10 years and has a net book value of US$7.5m, its tangible assets are estimated to have a fair market value in excess of their book value if applying the adjusted net asset approach. One of the reasons for this is that some equipment that was fully depreciated for accounting purposes is expected to have an economic useful life for years to come. In applying the adjustments, the value of the equity of Company A becomes US$12.5m.

When valuing income-generating businesses, the usefulness of this approach may be limited as it does not capture the future income-generating potential of the business or the value of its goodwill and other intangible assets. It does, however, present a reality check to the overall business valuation in providing an estimate of the potential lower end of the valuation range of the business. 

The asset-based valuation provides an indication of the downside risk

In order to correctly apply the asset-based valuation approach, a fundamental decision needs to be made upfront as to whether the net tangible assets of the business comprise part of a going concern entity or, alternatively, they do not and must be liquidated.

Taking our example further, if say, due to certain new industry regulations, the prospective viability of Company A as a going concern is uncertain, it would be appropriate to understand its value under a liquidation scenario. In determining the value using this approach, the intangible assets that cannot be sold separately from the business are excluded and the value is adjusted for estimated costs of disposal; implying a value of US$9m to Company A.

In instances where the business is a going concern, an assessment of the liquidation value acts as a useful measurement aid of the downside risk for an investor by providing an approximation of the net realizable value in the event the business is wound up shortly after investment. 

An asset-based valuation may not always represent the true value of a going concern

Back to our illustrative example, Company A and Company B are identical in all material aspects and have the same net book values. However, Company B has a significantly lower liquidation value as its tangible assets are not as valuable in the used equipment market. Considering its higher tangible asset backing, Company A will be perceived as a less risky investment to a potential equity investor or a debt provider. While US$9m may indicate a downside value for Company A given the operating risk from the new industry regulations, it is not necessarily representative of the actual value of Company A under a going concern scenario.

It is important to note that while making an assessment of the underlying tangible asset backing and the liquidity value is a useful tool when deciding on the value of a business, these do not necessarily represent the true value of a going concern. The asset-based valuation methods are more suited to valuation of going concern operations of asset-intensive businesses with little value from goodwill or intangibles, not-for-profit organizations or businesses to be purchased from a competitor in a similar industry.