The Asset Approach to Valuation
By Derek Oster, ASA, CVA, Manager, Advisory Services
As recently depicted in ESPN’s “The Last Dance” documentary, in 1991 Scottie Pippen famously signed a five-year, $18 million contract with the Chicago Bulls that would result in Pippen being one of the most notoriously underpaid players in sports history, as he played a crucial role in the building of the Bulls’ dynasty throughout the 90s. From the standpoint of the Bulls’ front office, however, Pippen’s contract was excellent as recorded on their books, since it represented only a small fraction of the money they could spend on other players (notably Michael Jordan). As such, Pippen’s true “value” to the Bulls was grossly underrepresented if looking only at the cap hit that Pippen’s contract had on the team.
Similarly, the value of a business’ net assets as presented on its balance sheet is typically not representative of business value. For the most part (with some exceptions), a company’s balance sheet is prepared using the cost basis of accounting – that is, where assets and liabilities are recorded at their historical purchase/acquisition cost, as opposed to the market value that the assets would command in a sale as of the balance sheet date. There is no theoretical support, conceptual reason, or empirical data to suggest that the value of a business will necessarily equal a company’s accounting book value.1
That said, current valuation theory does provide for methods to determine the value of an entity utilizing the balance sheet – specifically, by means of the asset approach.
What is the asset approach?
One of three general types of approaches to business valuation (in addition to the income approach and the market approach), the asset approach is a valuation technique whereby equity value is determined based on a market value balance sheet. The principal method used in the asset approach (and the method that this blog will focus on) is the Adjusted Net Asset Method. This method is used to value a business on the basis of the difference between the fair market value of its assets and its liabilities. Under this method, the assets are adjusted from book value to fair market value, and the total adjusted assets are then reduced by recorded and unrecorded liabilities.
The Adjusted Net Asset Method allows the analyst to establish a “floor-value” of a company based on the amount that would be realized upon a sale of a company’s assets and satisfaction of its liabilities. This method does not necessitate the actual termination or liquidation of the business, however. Rather, it sets a “floor value” of the business based on the underlying value of a company’s assets and liabilities as of the date of analysis.
Application of the Adjusted Net Asset Method is often used in the case of a holding company or a capital-intensive company, when losses are continually generated, or when valuation methodologies based on a business’ cash flow levels indicate a value lower than its net asset value.
Common Adjustments under the Adjusted Net Asset Method
One of the most common adjustments to inventory is for an entity that reports inventory on a last-in, first-out (“LIFO”) basis. LIFO may understate the current market value of inventory given that it expenses (i.e., moves out of inventory) items most recently purchased, resulting in a reported inventory balance comprised of costs incurred before the effective date of analysis and not necessarily representative of the current cost to replace. Current market value is better represented under a first-in, first-out (“FIFO”) method of accounting, as it is widely considered a better indication of fair market value at any given point in time. Therefore, it is generally accepted to adjust a company’s inventory to a FIFO basis when valuing a company that records inventory using a LIFO basis when applying the Adjusted Net Asset Method. Additionally, it is also appropriate to consider adjustments to write-off obsolete or slow-moving inventory.
The book value of a company’s real property (e.g., land, land improvements, buildings, etc.) or personal property (e.g., machinery and equipment, furniture and fixtures, vehicles, etc.) is often not reflective of fair market value. As such, it is common to engage a third-party appraisal specialist to determine the market value of such tangible assets.
Goodwill and Intangible Assets:
Goodwill and intangible assets are often written-down to zero value under the Adjusted Net Asset Method, as the value of these assets are better reflected by utilizing income- or market-based valuation approaches. While adjustments to write-off goodwill and intangible assets are not always necessarily required, if these items are present on a business’ balance sheet and the entity is not generating profits, then it may call into question the value of the assets, and further consideration is likely warranted.
Related Party (or Other) Receivables/Payables:
Consideration must be given to whether a receivable is fully collectible or a payable is expected to be fully paid. These are often the case for related parties – such as a loan to shareholders or an intercompany receivable. It is important to discuss any relevant accounts with management to ascertain whether or not an adjustment is required to account for potentially uncollectible receivables or payables that are likely never to be made.
It is also important to consider the impact of any unrecorded assets or liabilities, such as potential legal settlements or judgments.
Other Considerations and Key Takeaways
It is important to remember that while the Adjusted Net Asset Method can be utilized to determine an indication of value for nearly any business, it is common to employ this methodology (i) in the case of a holding company or capital-intensive company; (ii) when losses are continually-generated; or (iii) when valuation methodologies based on cash flow levels are lower than the entity’s net asset value. A company that consistently generates profits will often likely have its value better reflected via income- or market-based approaches. However, in these instances, the Adjusted Net Asset Method establishes a “floor value” that can be used to evaluate the reasonableness of the values indicated by income- or market-based methodologies.
Finally, keep in mind that the Adjusted Net Asset Method does not necessitate the actual termination or liquidation of the business. Many analysts confuse the use of an asset-based methodology with a liquidation premise of value. Rather, the Adjusted Net Asset Method can be used for a going-concern premise of value2 as well as a liquidation premise – provided the analyst appropriately adjusts any assets/liabilities in a manner consistent with the purpose and objective of the business valuation.
Do you have questions about valuation methodologies, or other valuation issues? Please contact Derek Oster at 440.459.5859 or email Derek.
- Valuing A Business – The Analysis and Appraisal of Closely Held Companies, Fifth Edition, Shannon Pratt, McGraw-Hill Publishing, 2008
- Whereby it is assumed the business is expected to continue operations and that management will retain the entity’s character and integrity as of the date of analysis into the future.