BUSINESS VALUATIONS: VALUING BUSINESSES UNDER THE ASSET APPROACH
By: James F. Sandkuhler, CPA, CVA, CFE

In previous articles, we have discussed three recognized approaches to valuing a business: the income approach, the asset approach and the market approach. This article will explore in depth the asset approach, which relies upon the theory that the value of a business can be measured by the cost of reproducing or replacing its assets.

The asset approach is a method that may be known by several names, including the net asset value method, the adjusted net asset value method, and the adjusted book value method. As each of these names suggests, this method is based upon the premise that the sum of the value of a business’ assets minus the value of its liabilities, equals the value of the owner’s equity in the business.

This is reminiscent of one of the basic equations of accounting theory taught in the first class of Accounting 101:
Assets - Liabilities = Equity or book value.

How simple business valuations would be if a mere examination of the company’s balance sheet provided an indication of value.

However, in most business valuation engagements, the standard of value is not accounting book value. Generally Accepted Accounting Principles (GAAP) require that most business assets be recorded on the books at their historical cost and, if appropriate, that those assets be depreciated over time.

For example, suppose your business acquired real estate several years ago at a cost of $1 million and over time $200,000 of depreciation has been recorded against that asset. Under GAAP, the book value of that real estate is $800,000, while in reality that property may have appreciated in value far beyond its original cost. If your business were to be valued using the adjusted net asset value method, that real estate would be restated at its appraised value as of the valuation date.

Similarly, all other material recorded assets and liabilities of the business would be restated from cost basis to reflect the appropriate standard of value, such as, fair market value. Accounts receivable, inventory, fixed assets, accounts payable, accrued expenses, long-term debt, etc., would all need to be separately identified and restated as appropriate.

The adjusted net asset value method requires that all material assets and liabilities of the business be restated. Obviously, the historical cost balance sheet as of the valuation date is a good starting point. However, the valuator’s task does not end with the restatement of the recorded assets and liabilities of the business.

This is due to another basic tenet of accounting theory. GAAP dictates that not all of a company’s assets (namely, intangibles) or liabilities (namely, contingencies) be recorded on the company’s books. Identifying and quantifying such unrecorded assets and liabilities can present the greatest challenge to the valuator using this valuation methodology.

Valuing intangible real estate such as easements or mineral rights and intangible personal property such as goodwill, patents, trademarks and copyrights, may involve the use of income approach methodologies or may require the input of other experts in the particular field involved. Measuring contingent liabilities such as pending litigation and tax disputes may require the legal opinion of corporate counsel as to the probable outcome of such actions.

Having restated all of the company’s assets and liabilities to the appropriate standard of value, simple arithmetic (total assets minus total liabilities) provides an indication of total enterprise value. This equation typically yields a value indication of 100% of the company’s equity, on a marketable, controlling interest basis. Depending upon the facts and circumstances (i.e., the ownership interest being valued, the purpose for which the valuation is being prepared, etc.) the application of discounts or premia may be appropriate (discounts for lack of marketability, minority interest discounts, control premia, etc.).

Use of the asset approach for business valuations in general, and the adjusted net asset value method, in particular, carries with it certain distinct advantages.

For starters, the conclusion of value is generally presented in the typically recognizable balance sheet format, allowing for easy identification of the value drivers of the business. If the current value of the business differs dramatically from its book value (as it often does), the major contributors to that difference are apparent.

With the components of value separately identified, the negotiation process in the context of structuring a sale is greatly simplified. Also, upon consummation of a sale, a means for allocating a lump sum purchase price to the various components of the deal is readily available.

Possibly the greatest disadvantage of this methodology is that the involvement of other appraisal specialists (real estate and fixed asset appraisers, for example) can add to the cost of the valuation process. Quantifying the value of certain intangible assets through one income approach or another can also add to the time and cost of the valuation.

Certified Valuation Analysts, James Sandkuhler, along with Joel Charkatz, chair the Business Valuation practice at the accounting and consulting firm, KAWG&F, P.A. For more information, contact them at 410-828-CPAS or e-mail Jim at jsandkuhler@kawgf.com.

Business Valuations article-asset approach.doc