The Asset-Based Valuation Approach

ANAV Method Illustrative Example

This discussion is the final installment of a series related to the asset-based business valuation approach. The prior discussion described the theory and methodology of the adjusted net asset value (ANAV) method. This final discussion presents an illustrative example of the application of the ANAV method.

[su_pullquote align=”right”]Resources:

Business Valuation Accelerator Clinic 2: Asset Approach

The Three Valuation Approaches—Challenges and Issues

Business Valuation Certification and Training Center

Intermediate Business Valuation Training Center

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Introduction

This discussion is the final installment of a series related to the asset-based business valuation approach.  The prior discussion described the theory and methodology of the adjusted net asset value (ANAV) method.  This final discussion presents an illustrative example of the application of the ANAV method.

Illustrative Example—No Individual Asset Revaluation

Let’s assume that an analyst is retained to estimate the fair market value of 100 percent of the owners’ equity of Gamma Client Company (Gamma) on a controlling, marketable ownership interest basis as of December 31, 2016.

The analyst decides to apply the asset-based valuation approach and the ANAV method.  The analyst decides to revalue the Gamma equity in the aggregate using the CEEM to conclude the Gamma total intangible value in the nature of goodwill.

The following table presents the Gamma historical cost-based balance sheet as of the December 31, 2016, valuation date.

Gamma Client Company

Balance Sheet

As of December 31, 2016

(in $000s)

Assets
Current Assets:
Cash	2,000
Accounts Receivable	3,000
Inventory	5,000
Total Current Assets	10,000
Property, Plant, and Equipment:
Land	10,000
Buildings	20,000
Equipment	30,000
Less: Accumulated Depreciation	(20,000)
Property, Plant, and Equipment, Net	40,000
Total Assets	50,000
Liabilities and Owners’ Equity
Current Liabilities:
Accounts Payable	2,000
Wages Payable	2,000
Taxes Payable	2,000
Total Current Liabilities	6,000
Long-Term Liabilities:
Notes Payable	14,000
Mortgages Payable	10,000
Total Long-Term Liabilities	24,000
Owners’ Equity
Total Owners’ Equity	20,000
Total Liabilities and Owners’ Equity	50,000

 

The analyst has worked with the management, performed a reasonable due diligence analysis, and concluded that the next period normalized EBIT will be nine million dollars.  For purposes of this analysis, the analyst concluded that EBIT was the appropriate measure of operating income to use in the CEEM analysis.

The analyst concluded that the appropriate fair rate of return on all of the Gamma tangible and intangible assets is 15 percent.  The analyst selected this rate of return based on the Gamma WACC.  The analyst concluded a zero percent expected long-term growth rate in excess earnings.  The analyst concluded a 15 percent direct capitalization rate.

The following table presents the CEEM analysis.  In this application of the ANAV method, the analyst does not revalue any of the Gamma assets—either the recorded tangible assets or the unrecorded intangible assets.  The analyst applies the CEEM analysis based on the GAAP basis balance sheet accounts.

Gamma Client Company

Adjusted Net Asset Value Method Analysis

Intangible Value in the Nature of Goodwill

As of December 31, 2016

(in $000s)

Capitalized Excess Earnings Method Valuation Analysis:

Gamma Account Balances:		Fair Rate of Return	Required Earnings
Working Capital Assets [a]	4,000	15%	600
Property, Plant, and Equipment	40,000	15%	6,000
Total Assets	44,000		6,600
Excess Earnings Analysis:
Gamma Next Period Normalized Earnings	9,000
– Gamma Required Earnings	6,600
= Gamma Excess Earnings	2,400
Capitalized Excess Earnings Analysis:
Gamma Excess Earnings	2,400
÷ Direct Capitalization Rate	15%
= Capitalized Excess Earnings	16,000
Intangible Value in the Nature of Goodwill	16,000
[a] Working capital assets = current assets minus current liabilities

 

The analyst prepared the ANAV method valuation-based balance sheet as of the December 31, 2016, valuation date.  The analyst adjusted the GAAP-based balance sheet for the result of the CEEM aggregate asset revaluation analysis.  This ANAV balance sheet is presented below.

Gamma Client Company

Asset-Based Approach Business Valuation

Adjusted Net Asset Value Method Analysis

As of December 31, 2016

(in $000s)

Assets
Current Assets:
Cash	2,000
Accounts Receivable	3,000
Inventory	5,000
Total Current Assets	10,000
Property, Plant, and Equipment:
Land	10,000
Buildings	20,000
Equipment	30,000
Less: Accumulated Depreciation	(20,000)
Property, Plant, and Equipment, Net	40,000
Intangible Assets:
Intangible Value in the Nature of Goodwill	16,000
Total Assets	66,000
Liabilities and Owners’ Equity
Current Liabilities:
Accounts Payable	2,000
Wages Payable	2,000
Taxes Payable	2,000
Total Current Liabilities	6,000
Long-Term Liabilities:
Notes Payable	14,000
Mortgages Payable	10,000
Total Long-Term Liabilities	24,000
Owners’ Equity
Total Owners’ Equity	36,000
Total Liabilities and Owners’ Equity	66,000

 

Based on the illustrative example fact set, the analyst performed the ANAV method to value the Gamma total equity.  The analyst applied the CEEM analysis to conclude the aggregate asset revaluation amount to include in the ANAV method valuation.  The analyst concluded $16 million as the total asset revaluation.  The analyst concluded $36 million as the fair market value of 100 percent of the Gamma owners’ equity as of December 31, 2016.

Illustrative Example—Tangible Asset Valuation

Let’s assume that the analyst is again retained to estimate the fair market value of 100 percent of the owners’ equity of Delta Client Company (Delta) on a controlling, marketable ownership interest level of value as of December 31, 2016.

The analyst decides to use the Asset-based Approach and the ANAV method.  The analyst decides to use the CEEM analysis to measure the appropriate total valuation adjustment to the GAAP-based balance sheet.  The analyst performs a due diligence analysis and estimates that Delta will generate nine million dollars of EBIT next year.  The analyst decides to use EBIT as the appropriate income metric to measure any excess earnings.  The analyst performs a WACC analysis and concludes that 15 percent is the appropriate rate of return on the Delta assets.  The analyst concludes a zero-expected long-term growth rate in the company excess earnings.  Therefore, the analyst concluded a 15 percent direct capitalization rate for the CEEM analysis.

The analyst can revalue certain assets that are already recorded on the Delta balance sheet.  The analyst performed a Market Approach analysis to value the inventory.  The analyst estimated the expected selling price of the inventory less the corresponding expected selling expense.  The analyst concluded a six million dollar fair market value for the inventory.

Management provided contemporaneous appraisals of the property, plant, and equipment.  Based on the Market Approach (and a sales comparison method analysis), the fair market value of the land was $12 million.  Based on the Cost Approach (and an RCNLD method analysis), the fair market value of the building was $14 million and the fair market value of the equipment was $24 million.  These assets (including the inventory) were appraised based on a value in continued use premise of value.

Since the analyst individually revalued account balances in this example, the analyst could have applied different required rates of return to each asset category.  For example, the analyst could have applied a lower (than 15 percent) rate of return to the inventory and tangible assets.  Then the analyst would have applied a higher (than 15 percent) capitalization rate as part of the goodwill-related valuation.  Using such a procedure, the analyst would have to ensure that the weighted average return on assets (WARA) equals the WACC in the CEEM analysis.

To maintain the simplicity of this illustrative example, the analyst consistently used the 15 percent WACC as the required rate of return on all of the asset categories in this CEEM analysis.

Since the analyst received or performed current valuations of certain asset accounts, the analyst used these valuations in the ANAV method analysis.  The analyst did not have valuations for any of the intangible assets.

Based on a Delta historical cost balance sheet that was equal to the Gamma historical cost balance sheet and based on the current values for the inventory and tangible assets, the analyst performed the CEEM analysis summarized in the following table:

Delta Client Company

Adjusted Net Asset Value Method Analysis

Intangible Value in the Nature of Goodwill

As of December 31, 2016

(in $000s)

Capitalized Excess Earnings Method Valuation Analysis:

Delta Account Balances:		Fair Rate of Return	Required Earnings
Working Capital Assets [a]	5,000	15%	750
Property, Plant, and Equipment [b]	50,000	15%	7,500
Total Assets	55,000		8,250
Excess Earnings Analysis:
Delta Next Period Normalized Earnings	9,000
– Delta Required Earnings	8,250
= Delta Excess Earnings	750
Capitalized Excess Earnings Analysis:
Delta Excess Earnings	750
÷ Direct Capitalization Rate	15%
= Capitalized Excess Earnings	5,000
Intangible Value in the Nature of Goodwill	5,000
[a] Working capital includes $11 million of current assets less six million dollars of current liabilities.[b] Property, plant, and equipment includes: $12 million of land, $14 million of buildings, and $24 million of equipment.

 

The analyst prepared the ANAV method valuation-based balance sheet as of the December 31, 2016, valuation date.  The analyst adjusted the GAAP-based balance sheet for both (1) the results of the separately valued individual asset accounts and (2) the conclusions of the CEEM analysis.  The ANAV balance sheet is presented below.

 

Delta Client Company

Asset-Based Approach Business Valuation

Adjusted Net Asset Value Method Analysis

As of December 31, 2016

(in $000s)

Assets
Current Assets:
Cash	2,000
Accounts Receivable	3,000
Inventory	6,000
Total Current Assets	11,000
Property, Plant, and Equipment:
Land	12,000
Buildings	14,000
Equipment	24,000
Property, Plant, and Equipment	50,000
Intangible Assets:
Intangible Value in the Nature of Goodwill	5,000
Total Assets	66,000
Liabilities and Owners’ Equity
Current Liabilities:
Accounts Payable	2,000
Wages Payable	2,000
Taxes Payable	2,000
Total Current Liabilities	6,000
Long-Term Liabilities:
Notes Payable	14,000
Mortgages Payable	10,000
Total Long-Term Liabilities	24,000
Owners’ Equity:
Total Owners’ Equity	36,000
Total Liabilities and Owners’ Equity	66,000

 

Based on the illustrative example fact set, the analyst performed the ANAV method to value the total equity.  The analyst (1) used current values for several asset categories and (2) applied the CEEM analysis to collectively revalue all other tangible assets and intangible assets.  Based on this CEEM analysis, the analyst concluded a five million dollar conclusion for the aggregate intangible value in the nature of goodwill.  Based on the ANAV method analysis, the analyst concluded a $36 million value for 100 percent of the Delta owners’ equity as of December 31, 2016.

Illustrative Example—Negative Goodwill

Let’s assume that the analyst is again retained to estimate the fair market value of 100 percent of the owners’ equity of Epsilon Client Company (Epsilon) on a controlling, marketable ownership interest level of value as of December 31, 2016.

The Epsilon December 31, 2016, historical cost basis balance sheet is the same as the Gamma December 31, 2016, historical cost basis balance sheet.  The analyst decided to use the Asset-based Approach and the ANAV method.

The analyst performs the due diligence analysis and concludes the same valuation variables used in the prior examples with regard to WACC, expected long-term growth rate in excess earnings, and direct capitalization rate.

The analyst has the opportunity to discretely appraise certain of the Epsilon asset categories.  Using the same Market Approach analysis, the analyst values the Gamma inventory at six million dollars.  Management provides the analyst with current fair market value appraisals of the property, plant, and equipment.  The land is valued at $12 million using the Market Approach, and the building is valued at $14 million using the Cost Approach.  The only difference between the Epsilon fact set and the Delta fact set is that, this time, management provides the analyst with a $30 million appraisal for the Epsilon equipment.  That $30 million fair market value conclusion is based on a Cost Approach and an RCNLD method analysis.

The analyst used the inventory and the tangible asset valuations in the ANAV method analysis.  The analyst did not have any intangible asset valuations.

Based on the historical cost balance sheet and the current valuations for the inventory and tangible assets, the analyst performed the CEEM analysis summarized in the following table.

Epsilon Client Company

Adjusted Net Asset Value Method Analysis

Intangible Value in the Nature of Goodwill

As of December 31, 2016

(in $000s)

Capitalized Excess Earnings Method Valuation Analysis:
Epsilon Account Balances:		Fair Rate of Return	Required Earnings
Working Capital Assets [a]	5,000	15%	750
Property, Plant, and Equipment [b]	56,000	15%	8,400
Total Assets	61,000		9,150
Excess Earnings/Income Shortfall Analysis:
Epsilon Next Period Normalized Earnings	9,000
– Epsilon Required Earnings	9,150
= Epsilon Income Shortfall	(150)
Capitalized Excess Earnings/Income Shortfall Analysis:
Epsilon Income Shortfall	(150)
÷ Direct Capitalization Rate	15%
= Capitalized Income Shortfall	(1,000)
Economic Obsolescence	(1,000)

[a] Working capital includes $11 million of current assets less six million dollars of current liabilities.

[b] Property, plant, and equipment includes $12 million of land, $14 million of buildings, and $30 million of equipment.

Since the “excess earnings” results in an income shortfall, the result of the CEEM analysis indicates the existence of economic obsolescence.  The analyst reflects the economic obsolescence by recognizing a proportional value decrease in all tangible and intangible assets that were valued by the application of the Cost Approach.

In the Epsilon valuation, none of the working capital accounts are valued by reference to the Cost Approach.  No identifiable intangible assets were valued in the Epsilon example.  Therefore, the analyst considered the tangible asset accounts.

The land was valued by reference to the Market Approach, so no economic obsolescence adjustment is necessary to the land value.  The buildings and equipment were both valued by the application of the Cost Approach and the RCNLD method.  The analyst makes an economic obsolescence adjustment to the building and equipment values.  This economic obsolescence adjustment is summarized in the table below.

Epsilon Client Company

Recognition of Economic Obsolescence

As of December 31, 2016

(in $000s)

Accounts Valued by the Cost Approach	RCNLD Indication	Economic Obsolescence		Economic Obsolescence %	Economic Obsolescence	Fair Market Value
Buildings	14,000			2.3 [a]	(300)	13,700
Equipment	30,000			2.3 [a]	(700)	29,300
Total Cost Approach Assets	44,000	(1,000)		2.3 [a]	(1,000)	43,000
[a] The 2.3 percent economic obsolescence percent is calculated as one million dollars economic obsolescence ÷ $44 million total RCNLD.

 

Based on the allocation of economic obsolescence, the final fair market value for the buildings is $13.7 million and the final fair market value for the equipment is $29.3 million.  The analyst can use these final value conclusions in the ANAV method analysis.  After this recognition of economic obsolescence, the CEEM analysis will conclude no positive intangible value in the nature of goodwill—and no negative goodwill related to a capitalized income shortfall.

The analyst prepared the ANAV method valuation-based balance sheet as of the December 31, 2016, valuation date.  The analyst adjusted the GAAP-based balance sheet for both (1) the results of the separately valued individual asset accounts and (2) the conclusion of the CEEM analysis (requiring an individual asset value adjustment for economic obsolescence).  The ANAV method balance sheet is presented below.

Epsilon Client Company

Asset-Based Approach Business Valuation

Adjusted Net Asset Value Method Analysis

As of December 31, 2016

(in $000s)

Assets
Current Assets:
Cash		2,000
Accounts Receivable		3,000
Inventory		6,000
Total Current Assets		11,000
Property, Plant, and Equipment:
Land		12,000
Buildings		13,700
Equipment		29,300
Property, Plant, and Equipment		55,000
Total Assets		66,000
Liabilities and Owners’ Equity
Current Liabilities:
Accounts Payable		2,000
Wages Payable		2,000
Taxes Payable		2,000
Total Current Liabilities		6,000
Long-Term Liabilities:
Notes Payable		14,000
Mortgages Payable		10,000
Total Long-Term Liabilities		24,000
Owners’ Equity:
Total Owners’ Equity		36,000
Total Liabilities and Owners’ Equity		66,000

 

Based on the illustrative example fact set, the analyst performed the ANAV method.  The analyst separately valued certain working capital and tangible assets.  The analyst applied a CEEM analysis to collectively revalue the remaining asset accounts.  Based on the CEEM analysis, the analyst did not identify any intangible value in the nature of goodwill.  Rather, the analyst quantified negative goodwill, indicating the existence of economic obsolescence.  The analyst adjusted the value of the cost-approach-derived asset accounts for the recognition of this economic obsolescence.

Based on the CEEM analysis (after the recognition of economic obsolescence), the analyst concluded zero dollars intangible value in the nature of goodwill.  Based on the ANAV method valuation, the analyst concluded a $36 million fair market value for 100 percent of the Epsilon owners’ equity as of December 31, 2016.

Summary and Conclusion

The Asset-based Approach is a generally accepted business valuation approach.  The ANAV method is a generally accepted Asset-based Approach valuation method.  The ANAV method typically involves the aggregate revaluation of all of the tangible and intangible assets.  However, the ANAV method can also be used if the analyst has access to the current valuations of any of the company assets (such as inventory or real estate).

All Asset-based Approach methods inform the client as to the tangible asset versus intangible asset source of value within the company.  Accordingly, both the asset accumulation (AA) method and the ANAV method can be applied to a company that is either tangible-asset-intensive or intangible-asset-intensive.  Both the AA method and the ANAV method can be used to value either operating companies or asset holding companies.  Both the AA method and the ANAV method can typically be applied to conclude various alternative standards of value and alternative premises of value.

All Asset-based Approach business valuation methods typically conclude a marketable, controlling level of value.  If the valuation assignment calls for a different level of value, then the analyst may consider the application of valuation adjustments—such as a discount for lack of marketability or a discount for lack of control.

Finally, the Asset-based Approach methods may be particularly applicable in business valuations when either the Income Approach or the Market Approach is not applicable for one reason or another.  And, the Asset-based Approach methods may be particularly useful as a supplemental or supporting business valuation method to be used in the reconciliation of Income Approach and Market Approach valuation methods.

 

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.