The asset approach is based on a calculation of the value of a business’s net assets.
When using the net asset value method, as it is also called, data from the company’s balance sheet is used. The book value of assets and liabilities.
An overly simplistic application of the method would imply subtracting the liabilities from the assets.
In practice, business valuation services must look beneath the surface because the net value of the company is rarely equal to the book value. The balance sheet needs to be adjusted – normalized.
For instance, reported assets often differ from the actual market value. The book value of machines, vehicles or real estate might be higher or lower than the actual market price.
The same holds true for liabilities.
When to use the Asset Approach?
The asset approach is a widely used valuation method among business appraisal services. While it certainly can be used for any company valuation, a business is usually worth more than its assets.
The ideal scenario for when to use the asset approach only, or mainly, is for sole proprietorships. One-man businesses are commonly highly dependent on the owner for running and developing the company. Any future value creation in the company will require a new owner to step into his or her shoes. Therefore, the market value of such a company usually equals its net assets.
Another situation when the asset approach is a suitable method is ahead of the liquidation of a company. A firm that will be deregistered has no more value than its net assets (minus the costs for the dissolution process).
That said – the asset approach may be used to better reflect the true value of any business when combined with another business valuation method, such as the income approach. When doing so the two methods used are weighted to obtain a well-balanced valuation reflecting the intrinsic value of the company.
The third valuation method frequently used by business valuation experts is the market approach. It is a way of determining the value of a company by looking at market valuations of similar businesses.
The market approach requires a large amount of data on recent transactions. Such information is mostly fetched from databases with historical transactions. Unfortunately, such datasets are rarely as complete as necessary to make an accurate estimate of the value of the business.
This method can be performed in one of two ways:
- Guideline public company method
- Guideline transactions method
The guideline public company method
This market approach method uses data from similar companies within the same industry, but they are publicly traded on an exchange.
The idea is that their multiples will also apply to a private company.
Data is often obtained from databases such as Bloomberg, TagniFi and Capital IQ.
A business appraisal company using this market approach method will have to make various considerations and adjustments for risk, size and other factors that can affect the valuation.
Often it is almost impossible to get any reliable valuation based on the guideline public company method due to the vast differences between public and private firms. There are for example often significant differences in size and geographical diversification.
Or simply because there might be an insufficient amount of similar public companies to compare with.
The fact that public companies are often traded with a premium to private companies and because of the high volatility of market prices, this method can be difficult to apply in practice.
Guideline transactions method
The option for business valuation services wanting to use the market approach is to apply the guideline transactions method instead. It is similar to the guideline public company method but relies solely on transactions in mergers and acquisitions (M&A).
The main difference here is that transaction data is derived from a single transaction, a stark contrast to the daily share price changes of public companies.
Data is extracted from databases also in this case, such as BizComps, Pratt´s Stats, Done Deals, BVR and more. Importantly, here there is the option to look at public and private companies separately. Often, mergers and acquisition data stemming from similar private companies is a better benchmark for determining the value of the company.
When to use the Market Approach?
While the market approach might appeal with its non-fuzz reality-based valuations, a general lack of data despite extensive databases is often the main concern.
A second challenge is to apply that information to the specific company in question. Differences and company specifics often warrant a different valuation than the one of the average similar business, to a degree where such adjustments become very challenging to execute.
That said, the market approach is often the method of choice by business appraisal services wishing to evaluate local businesses such as restaurants, bars, brick-and-mortar retail stores and similar.
Essential to normalize the income statement before the valuation
Regardless of the choice of method, the importance of normalizing the income statement before making any calculations cannot be emphasized enough.
What this means is to “cleanse” the numbers from non-recurring and unusual items such as for example gains from a sale of an asset, one-time legal settlements, restructuring costs or life insurance proceeds.
It can also mean adjusting for discretionary items such as compensation to owners working in the company. The owners might be getting a salary below the market rate. Or compensation in the form of an expensive car or yacht, which could not have occurred in a publicly traded company.