Asset-based valuation is a form of valuation in business that focuses on the value of a company’s assets or the fair market value of its total assets after deducting liabilities. Assets are evaluated, and the fair market value is obtained.
For example, landowners may collaborate with appraisers to work out a property’s market worth. Over time, property values increase, and a proprietor may realize a piece of property is worth more today than it was five years ago. The new value is quoted and is used in the asset-based approach. On the other hand, liabilities often occur at true market value. Usually, no further calculations are done. Asset valuation determines the cost of recreating a similar business.
Breaking Down the Asset-based Valuation Approach
Cost includes actual machinery and equipment, as well as furniture. However, it’s important to note that cost comprises lost income, especially in cases where a business is listed. Items wear out, and they need to be replaced eventually.
Additionally, the valuation process should consider economic and functional obsolescence. Some companies own intangible assets like technology that are outdated. For example, a business that still makes use of vacuum tubes while rivals are enjoying nanotech is an indication of an organization living in the past.
The asset-based valuation method is sound because there’s plenty of flexibility regarding the interpretation when it comes to making a decision on the assets and liabilities to consider in the valuation.
Asset-based Valuation Methods
1. Asset Accumulation Valuation
The asset accumulation method bears a striking superficial similarity to the widely known balance sheet. In the asset accumulation method, all the assets and liabilities of a business are compiled, and a value is assigned to each one. The value of an entity is the difference between the value of its assets and liabilities.
As simple as it sounds, as always, the burden lies in the details. Each asset and liability must be identified carefully. In addition, the asset accumulation method requires an effective way of assigning values to assets and liabilities.
A few of the items typically used during valuation don’t always appear on a standard balance sheet. They include internally generated intangible assets like trademarks, patents, as well as trade secrets. The list also contains provisional liabilities, which may comprise compliance costs or unresolved legal cases.
2. Excess Earnings Valuation
On the other hand, the excess earnings approach is a combination of the income and assets valuation methods. Other than evaluating a company’s tangible assets and liabilities, the method can also be used to work out a business’s goodwill.
To determine goodwill, the earnings of a business are treated like input, and then a connection is drawn to the income method. As a result, the excess earnings method is highly preferred when valuing strong businesses with substantial goodwill.
Typical examples include businesses that offer professional services like accounting and law firms, engineering and medical practices, as well as architectural firms. The excess earnings method is also useful during the valuation of manufacturing enterprises and well-established technology companies.
Business Value vs. Selling Price
The selling price of a business and its value are not the same. The reason businesses conduct asset-based valuation is to find out what an entity would go for, theoretically speaking. However, practically speaking, the value of an entity varies, based on the person doing the valuation.
So, an overexcited buyer looking to replace losses can choose to pay a substantial sum just to acquire a business. Financial buyers tend to pay quite low when acquiring a business.
There is also market exposure, which plays a significant part as well. Pitching the business to potential buyers is only half the task when looking to achieve the best price.
Pros and Cons of Asset-based valuation
Most companies use the appropriate asset valuation method in cases where they are experiencing issues relating to liquidation. Companies in the investment niche – like financial or real estate investment, where assets are calculated based on income or market approach – can also use asset-based valuation.
That said, asset-based valuation is not without its drawbacks. Unlike other methods, such as the income approach, the asset-based method disregards a company’s prospective earnings. Putting concerns aside, an entity’s business value can be much higher compared to when its existing assets are disposed of item by item.
Since internally generated products don’t appear on the balance sheet, the process of measuring intangible resources can be quite complicated.
Valuing a company requires much more than just science. Asset valuation requires profound knowledge, as well as experience, accuracy, and attention to detail. Many businesses find the process quite complicated, which discourages them from undertaking individual business valuation.
Sometimes, the asset-based method becomes complex because few businesses lack the required level of objectivity and accuracy necessary to estimate their actual worth.
While there are several methods that can be used to value a business, asset-based valuation is often preferred because of its applicability in instances where a business is suffering from challenges relating to liquidity.
The asset-based method is highly favorable for core niches like the real estate sector. However, it comes with its own disadvantages, such as the fact that it’s quite complex, especially for those with little experience.
Thank you for reading CFI’s guide to Asset-Based Valuation. To keep learning and advancing your career, the following resources will be helpful:
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