The Asset-Based Valuation Approach

The Adjusted Net Asset Value Method

This discussion is the fifth part in a series regarding the asset-based business valuation approach. Previous discussions described the theory and application of the Asset-based Approach. And, previous discussions described the theory and application of the asset accumulation (AA) method. This discussion describes the theory and application of the adjusted net asset value (ANAV) method.

[su_pullquote align=”right”]Resources:

The Three Valuation Approaches—Challenges and Issues

Business Valuation Accelerator Clinic 2: Asset Approach

Business Valuation Certification and Training Center

Advanced Valuation: Applications and Models Workshop

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Introduction

This discussion is the fifth part in a series regarding the asset-based business valuation approach.  Previous discussions described the theory and application of the Asset-based Approach.  And, previous discussions described the theory and application of the asset accumulation (AA) method of the Asset-based Approach.  This discussion describes the theory and application of the adjusted net asset value (ANAV) method.

Like other Asset-based Approach methods, the ANAV method typically concludes a marketable, controlling ownership interest level of value.  If the valuation subject is a different level of value (say a nonmarketable, noncontrolling ownership interest in the company common stock), then the analyst may identify and quantify appropriate valuation adjustments.  Such adjustments could include a discount for lack of marketability, a discount for lack of control, or a discount for contractual transferability (or other) restrictions.

The ANAV method is not the same analysis as the so-called net book value (NBV) method.  In fact, the NBV method is not a generally accepted business valuation method.  The NBV “method” is a financial accounting calculation.  In the so-called NBV method, the analyst relies entirely on data from the company’s financial statements, without the application of valuation analyses or analyst professional judgment.  The analyst subtracts the recorded amount of liabilities (both current and noncurrent) from the recorded amount of assets (both current and noncurrent).  This calculation provides what is often called the net book value.

This NBV calculation describes the mathematical relationships between the assets and the liabilities recorded on the balance sheet.  For a balance sheet prepared in accordance with generally accepted accounting principles (GAAP), these accounts should typically be recorded on a historical cost basis.  That historical cost basis is typically not indicative of a current value estimation for the subject company assets and liabilities.

In contrast, the ANAV method may start with the NBV of the company assets and liabilities.  Then, the analyst applies professional judgment and employs a series of valuation procedures.  The result of these valuation procedures is a current value estimation of the subject company.

ANAV Methodology

The analyst typically starts with a GAAP-based balance sheet.  The analyst uses the balance sheet dated closest to the subject analysis valuation date.  Preferably, the analyst uses the company’s balance sheet that was prepared just before the valuation date.

The analyst identifies and separates (for further analysis) any nonoperating or excess assets reported on the balance sheet.  Such assets may include vacant land or other assets held for investment purposes.  Such assets may also include those that are not necessary for the business but that are enjoyed primarily by the business owners.  This asset category may include a private aircraft or a vacation home owned by the company.  And, nonoperating assets sometimes include the tangible assets of company discontinued operations that are being held for disposal.  These excess or nonoperating assets are analyzed separately from the ANAV valuation of the going concern business.

The analyst lists all of the reported account balances for the following categories of business operating assets:

1. Working capital assets (including current assets less current liabilities)
2. Tangible assets (including land, buildings, and equipment)
3. Intangible assets (including any recorded identifiable intangible assets)
4. Other assets (such as deferred income taxes and unconsolidated investments)

The sum of these recorded asset balances represents the amount of the company’s total net operating assets.  The total operating assets is typically analyzed net of the current liabilities accounts.  For this purpose, the current liability component of any long-term debt is typically excluded from this total.  The total net operating assets should equal the total long-term debt (including the current portion of that debt) plus the total owners’ equity recorded on the balance sheet.

The analyst begins the process of performing an aggregate revaluation of all the total net assets.  A common valuation method used to perform this single, collective revaluation of the net operating assets is the capitalized excess earnings method (CEEM).  The result of the CEEM analysis is often called intangible value in the nature of goodwill.

This CEEM goodwill value represents the total value increment (or value decrement) compared to the company’s recorded cost-based net operating assets.  That is, this CEEM goodwill calculation may not represent the same goodwill calculation that could be indicated by the asset accumulation (AA) method of or by the acquisition accounting method residual goodwill calculation.  For both the AA method and the acquisition price allocation analysis, goodwill represents an individual intangible asset.  That goodwill intangible asset is quantified after: 1) all of the tangible assets have been revalued; and 2) all of the identifiable intangible assets have been revalued.

In the CEEM analysis, the goodwill calculation typically includes all of the following:

1. The total revaluation (above the cost-based accounting balance) of the recorded tangible assets;
2. The total revaluation (above the cost-based accounting balance) of all of the recorded intangible assets;
3. The total valuation of all of the identifiable but unrecorded intangible assets; and
4. The valuation of any remaining business value in excess of the value increment associated with the recorded tangible assets, recorded intangible assets, and unrecorded intangible assets.

In the CEEM analysis, the value conclusion represents more than the value of the residual goodwill amount.  The CEEM value conclusion represents an aggregate revaluation of all of the recorded balance sheet accounts.  The CEEM conclusion is often referred to as intangible value in the nature of goodwill.  That name is intended to distinguish the CEEM goodwill adjustment from the residual amount of goodwill that is concluded in an AA method analysis or in a purchase price allocation.

The CEEM analysis involves multiplying a fair rate of return by the company’s net operating assets balance.  The mathematical product of this multiplication is called the required earnings.  The analyst compares the required earnings to the company’s actual earnings.  If the actual earnings exceed the required earnings, then the company is generating excess earnings.  The excess earnings are typically capitalized as an annuity in perpetuity.  The capitalized excess earnings represent the intangible value in the nature of goodwill.

The analyst adds the net operating assets balance to the goodwill balance calculated from the CEEM analysis.  This summation represents the current value indication for all of the net assets (i.e., total assets minus current liabilities).  The analyst can also subtract the long-term debt from the calculated net asset value indication.  The remainder of that subtraction process indicates the current value of the owners’ equity.

As a final procedure, the analyst adds the value of any excess or nonoperating assets to the value of the net operating assets—in order to conclude a total business value.

Strengths of the ANAV Method

The first ANAV method advantage is that it is relatively quick and easy to perform.  For the most part, the analyst only needs the company’s historical financial statements in order to perform the ANAV analysis.  In other words, the ANAV is based on the same company financial data that the analyst would collect in order to perform either a Market Approach or an Income Approach business valuation.

In contrast, the AA method analysis requires valuations of each category of the tangible assets and intangible assets.  In contrast to the AA method, the ANAV method does not require the time or the cost of either: 1) the analyst performing numerous tangible asset and intangible asset valuations; or 2) a third-party appraisal specialist performing numerous tangible asset and intangible asset valuations.

The second ANAV method advantage is that it is relatively easy to explain and relatively easy for parties relying on the business valuation to understand.  The application of the AA method often involves the use of numerous valuation approaches and methods.  And, the AA method involves valuations of interrelated assets.  Considerations related to contributory asset charges and profit split analyses are often difficult for parties relying on the valuation to understand and follow.

A third ANAV method advantage is that it is intuitively obvious.  The analysis starts with the balance sheet.  If the company earns an amount of income greater than a fair return on its balance sheet assets, then the business value is proportionately greater than its NBV.  If the company earns an amount of income less than a fair return on its balance sheet assets, then the business value is proportionately less than its NBV.

Fourth, because of the relatively limited data requirements, the analyst does not have to disrupt the company business operations.  The analyst typically does not need to conduct burdensome management interviews or make obtrusive company visits (as often is the case with the AA method).  It is easier for the analyst to perform the ANAV method (than the AA method) in a litigation environment.

Fifth, the ANAV method can be used effectively and efficiently to identify whether or not the company is earning a fair return on investment for the owners.  This business valuation method also quickly identifies whether the GAAP balance sheet overvalues or undervalues the company’s net assets (in the aggregate).

In summary, the ANAV method allows the analyst to perform an Asset-based Approach analysis without the cost and time requirements of the AA method.  Such an analysis is usually sufficient to allow the analyst to reconcile the ANAV value indication with the Market Approach and the Income Approach value indications in order to synthesize an overall business value conclusion.

Weaknesses of the ANAV Method

First, the ANAV method can be used to conclude the company: 1) total asset value; 2) total business enterprise (long-term debt plus equity) value; or 3) total equity value.  It cannot be used to estimate the value of any asset or bundle of assets.  It does not effectively distinguish between tangible asset value and intangible asset value.  And, it cannot identify the value of assets that are pledged as debt collateral—compared to the value of assets that are available to pledge as debt collateral.

Second, the ANAV method may be deceptively simple.  Clients, counsel, judicial finders of fact, and other parties relying on the valuation need to appreciate the importance of each valuation variable in the methodology.  There are different versions of the ANAV method.  Some versions involve no revaluation of the company assets.  Other versions allow for limited revaluation of certain assets (such as real estate).  And, issues such as the selection of the fair rate of return on assets, the consistency of the level of company income and the rate of return measurement, and the selection of the direct capitalization rate are more complex than they may seem on the surface.

Third, the ANAV method concludes a business value for the company.  However, and unlike the AA method, the ANAV method does not identify the source of the business value.  That is, the ANAV method does not determine if any company excess earnings is due to efficient plant and equipment use, strong customer relationships, valuable intellectual property assets, or any other reason.

Fourth, the ANAV method typically does not identify asset spin-off opportunities, undervalued asset refinancing opportunities, or intellectual property license opportunities.  In other words, this method indicates a reasonable business value conclusion.  But, this method is limited with regard to telling the company management how to maximize (or even increase) the value of the company.

Fifth, the ANAV method has application limitations regarding comparing business values under alternative standard of value scenarios and alternative premise of value scenarios.  As a relatively simple methodology, the ANAV method typically concludes a market-based standard of value and a going concern premise of value.  It is difficult to adjust the valuation variables to conclude alternative standards of value or alternative premises of value.

In summary, the analyst should be aware of the importance of each individual valuation variable in the ANAV method.  The analyst should appreciate that the ANAV method produces a reasonable indication of the current business value.  However, this method has somewhat limited application when it comes to analyzing issues related to alternative tax structures, financing structures, transaction structures, and so forth.

Specific Issues in the ANAV Method

There are several technical issues in the application of the ANAV method.  Most of these issues relate to the importance of internal consistency in the selection of the valuation variables.  Some of these issues relate to the analyst’s professional judgment regarding the direction (increasing or decreasing) and duration (limited or perpetual) of any company excess earnings.

The first issue is that (as with any valuation method) there are alternative versions of the ANAV method.  In the simplest application of the method, none of the company assets or liabilities are restated from their balance sheet account balances.  That is, each asset and liability category is stated at their historical cost balance as presented on a recent GAAP balance sheet.

Alternatively, sometimes the analyst has current values available for some (but only some) of the company’s recorded assets.  For example, the company management may present the analyst with contemporaneous appraisals of the real estate or other tangible assets.  The analyst should understand the purpose and objective of such appraisals before incorporating them into the ANAV analysis.  The analyst can use the ANAV method based on current appraisals of some of the assets—but not others.

If the analyst is careful in selecting valuation variables, any value appreciation that is accounted for in the tangible asset appraisals should reduce the value concluded in the CEEM analysis.  That is, part of the company value may be transferred from the CEEM intangible goodwill value to the appraised tangible asset value.  Other than for rounding errors, the total business value should remain the same.

The analyst has to decide what level of company income should be included in the CEEM analysis.  Some of the common alternative levels of income include: EBIT, EBITDA, net operating income (EBIT after taxes), and net cash flow.  Any of these alternative measures of the income may be used in the CEEM analysis.  The analyst should select both, (1) a rate of return, and (2) a capitalization rate that are consistent with the level of income selected to measure the required earnings level and the actual earnings level.

All income measures and all rate measures should be calculated based on the same level of income regarding income taxes, interest expense, depreciation expenses, and so forth.

Some analysts apply the CEEM calculation by assigning a single fair rate of return to all asset categories.  In this version of the CEEM, the single fair rate of return is often the company weighted average cost of capital (WACC).  In this version, each asset category is assigned a portion of the total earnings based on the asset category balance multiplied by the WACC.  This version is a common application of the CEEM, based on a simplifying assumption that all assets have the same degree of investment risk.  In this CEEM application, the direct capitalization rate used to capitalize any excess earnings is also based on the WACC.

All analysts have to make a decision with regard to the expected future growth related to any excess earnings (or to any negative earnings—or income shortfall).  This decision is quantified in the direct capitalization rate used to capitalize any excess (or deficiency) earnings.  If the analyst does not expect the excess earnings to increase (or decrease) over time, then the capitalization rate will equal the WACC.  If the analyst expects the excess earnings to increase at the rate of positive g percent over time, then the capitalization rate will typically be: (WACC – g)%.  And, if the analyst expects the excess earnings to decrease at the rate of negative g percent over time, then the capitalization rate will typically be: (WACC + g)%.

The most important factor that analysts should consider in the ANAV method is consistency.  When the analyst uses the CEEM to measure an intangible value in the nature of goodwill, all of the valuation variables within the analysis should be internally consistent.

How to Handle Negative Goodwill

Based on the application of the CEEM, it is possible to calculate a negative figure for the intangible value in the nature of goodwill.  This result will occur any time the company’s required earnings are greater than the company’s expected actual earnings.  When the company is generating deficit earnings (instead of excess earnings), the capitalization of the earnings deficiency will indicate negative goodwill.

Negative goodwill would not be reported on a balance sheet prepared in compliance with GAAP.  And, negative goodwill should not be reported on the valuation-based balance sheet prepared as part of an ANAV method analysis.  The CEEM-derived negative goodwill should be eliminated by reducing the concluded value of the previously valued tangible assets and identifiable intangible assets.  The CEEM result of negative goodwill is an indication that the company is experiencing economic obsolescence.  In fact, the mathematical result of negative goodwill is one common procedure for measuring economic obsolescence.

Economic obsolescence occurs when an operating company does not earn a fair rate of return on the indicated value of its tangible assets and intangible assets.  The existence (and measurement) of economic obsolescence indicates all the assets that were valued by reference to a Cost Approach method should be decreased in value (by the amount of the economic obsolescence).  Typically, the analyst decreases the value of all the cost-approach-measured assets (both tangible and intangible) until the amount of economic obsolescence is reduced to zero.

Let’s assume that the CEEM analysis indicates a one million dollar negative goodwill conclusion.  This conclusion indicates the existence of economic obsolescence.  Let’s assume that the analyst previously valued other tangible and intangible assets using the Cost Approach and the RCNLD method.  The sum of all the other cost-approach-derived asset values was $10 million.  In this case, the analyst would reduce the cost-approach-derived asset values by 10 percent (one million dollars economic obsolescence divided by $10 million total RCNLD).  The resulting Cost Approach value conclusions—after economic obsolescence—would be nine million dollars.  At a nine million dollar total tangible and intangible asset value conclusion, the CEEM analysis should indicate zero dollars of goodwill—and zero dollars of remaining economic obsolescence.

In the recognition of economic obsolescence, the analyst will typically decrease asset values that were concluded using a Cost Approach valuation method.  This is because assets that were valued by reference to either Income Approach methods or Market Approach methods have already recognized the owner/operator’s economic obsolescence in the value conclusions.  For example, the income projections and the discount and capitalization rates used in the Income Approach valuations should be implicitly influenced by the existence of economic obsolescence.  The market-derived sales and the market-derived lease and royalty rates should be implicitly influenced by the existence of economic obsolescence.  These statements are true for the valuations of both tangible assets and intangible assets.

Therefore, the income-approach-valued assets and market-approach-valued assets do not need to be explicitly adjusted for economic obsolescence.  In contrast, the cost-approach-valued assets do need to be explicitly adjusted for economic obsolescence.  The analyst adjusts the value of these tangible and intangible assets for economic obsolescence until all of the CEEM-derived negative goodwill is eliminated from the analysis.

Summary

This discussion summarized the common procedures related to the application of the ANAV method.  Along with the AA method, the ANAV method is a generally accepted Asset-based Approach method to value a closely held business or business ownership interest.  The next and final installment of this series presents several illustrative examples of the application of the ANAV method to a hypothetical business valuation.

Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, CBA, is a managing director of Willamette Management Associates based in Chicago. His practice includes business valuation, forensic analysis, and financial opinion services. Throughout his notable career, Mr. Reilly has performed a diverse assortment of valuation and economic analyses for an array of varying purposes.
Mr. Reilly is a prolific writer and thought leader who can be reached at (773) 399-4318, or by e-mail to rfreilly@willamette.com.