The Asset Approach – What is an Asset Based Valuation?
The Asset-Based Approach in Brief
Using an asset-based approach to business valuation means basing the valuation on the net asset value of the business. This is done by subtracting all liabilities from total assets. To represent the fair market value of the business, you must use the market value of the assets and liabilities, not just the book value.
When To Do an Asset Based Valuation?
- In most valuations: Used with the income approach to provide a balanced valuation that considers both assets and income. It may also be combined with the market approach.
- To value asset-heavy businesses: Whenever there is significant equipment, inventory, or other assets, an asset approach valuation is appropriate. Also useful for valuing investment companies, real estate businesses, and holding companies.
- When other methods don’t work: Also applicable when there is no profit or even sufficient cash flow.
- For liquidation: An asset-based valuation can be used to value a business that is distressed or facing liquidation. In such cases, a discount rate is applied to the valuation.
- For simple valuations: It does not require risky assumptions or complex projections and is good for determining a minimum value of the business.
Making an Asset Approach Valuation – Step by Step
A company’s net worth is equal to its total assets minus its total liabilities. On the balance sheet this is called equity.
If you just looked at the value of the equity on the balance sheet, the valuation would be done in less than a minute. The problem with this approach is that the market value of assets rarely equals their book value. On the balance sheet, the value of assets is regularly reduced by depreciation. Their true market value is often higher, but it can also be lower. This problem does not affect liabilities to the same extent, but they must be considered as well.
Example:
- A company purchases a truck for $1 million.
- The accountant uses IRS MACRS depreciation and a 5-year class life. This means that after 5 years, the book value of the truck is close to zero.
- However, it is not uncommon for heavy trucks to have a 40%-50% salvage value after 5 years.
- If the appraiser had used the book value of the truck, he would have undervalued it by approximately $500,000.
Therefore, when performing an asset based valuation, it is important to first normalize the balance sheet to reflect current market prices.
How To Do an Asset-Based Valuation
- Use the balance sheet to identify key assets and liabilities.
- Are there intangible assets, such as patents, trademarks, or brands, that are not on the balance sheet? Such assets may need to be considered, especially before a transaction.
- Perform an asset valuation to determine the market value of each asset. Update the balance sheet.
- Look at the liabilities and adjust them if necessary. For example, there may be contingent liabilities such as guarantees or lawsuits, off-balance sheet liabilities, debt restructuring, or the like.
- Subtract the liabilities from the assets. Now you have the net asset value of the company.
Pros and Cons with an Asset Based Approach Valuation
The beauty of the asset approach is its simplicity. Assets and liabilities are usually easy to identify. This approach provides a quick and robust way to calculate the value of a business without having to use complex formulas or heavy assumptions.
However, the amount of work that goes into a reliable business valuation using the asset approach is easily underestimated. Simply using book value will lead to incorrect results. Most of the work goes into finding the true market value and identifying off-balance sheet assets and liabilities.
Income And Profits are Ignored
Earnings or growth are not reflected in an asset based valuation. Often it does not even include intangible assets, but that is up to the appraiser to decide. However, it is a tedious task to determine the value of intangible assets.
Sometimes the asset based approach can be used as the only valuation method. For example, if you need to quickly determine an approximate floor price for your business, this approach will help. It is also useful when valuing a business to be liquidated.
Often Used with Other Approaches
However, the full potential of the asset approach is realized when used in conjunction with other valuation approaches. At Nielsen Valuation Group we often use it on top of an appraisal done with the income approach, to provide a balanced and fully IRS compliant valuation.
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Nielsen Valuation Group provides unbiased and Revenue Ruling 59-60 compliant business valuations that reflect real-world transactions. Contact us today for a free 30-minute consultation.
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