The Asset-Based Valuation Approach

Introduction

Valuation analysts are retained to value closely held businesses, business ownership interest, and securities for a variety of transaction, financing, taxation, accounting, litigation, and planning purposes. For each engagement, analysts consider the three generally accepted business valuation approaches: the Income Approach, the Market Approach, and the Asset-based Approach. However, most analysts rarely apply the Asset-based Approach in the typical business valuation. This column is part of a series of discussions related to the application of the asset-based valuation approach.

[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

Valuation analysts (analysts) are retained to value closely held businesses, business ownership interest, and securities for a variety of transaction, financing, taxation, accounting, litigation, and planning purposes.  For each engagement, analysts consider the three generally accepted business valuation approaches: the Income Approach, the Market Approach, and the Asset-based Approach.  However, most analysts rarely apply the Asset-based Approach in the typical business valuation.  This column is part of a series of discussions related to the application of the asset-based valuation approach.

The Asset-based Approach is a generally accepted business valuation approach.  The Asset-based Approach is described in most comprehensive business valuation textbooks.  Consideration of the Asset-based Approach is required by most authoritative business valuation professional standards.  For example, the American Institute of Certified Public Accountants) (AICPA) Statement on Standards for Valuation Services (SSVS) and the Uniform Standards of Professional Appraisal Practice (USPAP) require consideration of the Asset-based Approach.  Such professional standards require the consideration of—but not necessarily the application of—the Asset-based Approach.  In practice, many analysts immediately reject Asset-based Approach valuation methods as being too difficult, too time consuming, too client disruptive, or simply (and without adequate explanation) not applicable to the subject closely held company.

Many analysts do not seriously consider applying the Asset-based Approach in the typical business valuation.  These analysts are not sufficiently familiar with the generally accepted methods and procedures within this approach.  Many analysts labor under misconceptions about when—and when not—to apply this approach.  And, many analysts also hold misconceptions about interpreting the quantitative results of the asset-based valuation approach.  This series of discussions will address many of the common misconceptions about this business valuation approach.

The application of this valuation approach requires a slightly different set of skills than does the application of the Income Approach or the Market Approach.  Not all analysts have the experience or expertise to perform a comprehensive Asset-based Approach analysis.  The completion of the Asset-based Approach often requires more analyst time than other business valuation approaches.  That additional analyst time typically translates into additional professional fees to the client.  Therefore, clients often discourage the use of the Asset-based Approach when they learn of both the additional time and the additional costs associated with this valuation analysis.  This valuation approach often requires more data from—and more involvement by—the closely held company executives.  When these additional commitments are understood, many clients discourage the use of the Asset-based Approach.

In many controversy-related assignments, the analyst may not be granted access to the company facilities or executives.  Particularly in a retrospective controversy-related assignment, the data that the analyst needs—and the personnel that the analyst needs access to—are simply no longer available.  In some instances, it may simply be impractical to perform some Asset-based Approach valuation methods.

Theory of the Asset-based Approach

The Asset-based Approach is sometimes called the Asset Approach to business valuation.  Either term is generally accepted.  The Asset-based Approach encompasses a set of methods that value the subject company or security by reference to its balance sheet.  In contrast, Income Approach and Market Approach valuation methods focus on the company’s income statement and/or cash flow statement.

An important procedure in any business valuation is to define the business ownership interest subject to valuation.  The assignment should specify whether the analysis intends to conclude a defined value for the subject company:

1. total assets,
2. total long-term interest-bearing debt and total owners’ equity,
3. total owners’ equity, or
4. one particular class of owners’ equity.

Each of these descriptions is a valid objective of a business valuation.  And, each conclusion is often referred to as a “business value.”  However, each of these business value conclusions will be quantitatively different for the same company.  Each of these business value conclusions will be appropriate in the right circumstance—usually based on the actual or hypothetical transaction that is being analyzed.

The subject company’s total asset value is important in an acquisition structured as an asset purchase (instead of as a stock purchase).  The company’s total invested value (TIC)—often called the market value of invested capital (or MVIC)—is the value of all interest-bearing debt plus all classes of owners’ equity.  Estimating the value of the TIC is important in a deal structure where the buyer will acquire all the company’s equity and assume all of the company debt.  Estimating the value of the total owners’ equity is important when only the company’s equity securities (say all common stock and all preferred stock) are transferred in the transaction.  And, estimating the value of one particular class of equity only (say only the company’s common stock) is important when only that class of security is transferred in the transaction.

The Asset-based Approach is based on the principle that the value of the equity of a company is equal to:

the value of the company total assets

minus

the value of the company total liabilities

If properly applied, this valuation formula can be used to indicate the value of any of the valuation objectives listed above.  However, there are two foundational words in the above formula: 1) value and 2) total.

The Asset-based Approach is based on the value of (and not the recorded balance of) the subject company’s assets and liabilities.  The standard of value in the analysis has to be defined.  The valuation date of the analysis has to be defined.  The standard of value is determined by the assignment.  Common standards of value for taxation and accounting purposes include fair market value and fair value.  Other common standards of value include investment value, owner value, use value, user value, and others.  Whatever the assignment-specific standard of value is, the value conclusion is likely going to be different from the recorded account balances presented on the company’s balance sheet.  Those balance sheet recorded account balances are probably presented in compliance with generally accepted accounting principles (GAAP).  Those account balances typically include a combination of historical cost-based measures and GAAP-based fair value measures.

The Asset-based Approach is also based on the total of all of the company’s assets and liabilities.  GAAP-based balance sheets typically exclude major categories of assets and liabilities.  GAAP-based balance sheets do not record most internally created intangible assets.  In the information age, such intangible asset categories often represent the major sources of value for any business entity.  This statement is obvious for technology-related companies.  This statement is also true for most companies.  Under U.S. GAAP, the values of internally created employee relationships, supplier relationships, customer relationships, and goodwill are not recorded on the balance sheet.  The value of the entity’s contingent liabilities are not recorded under U.S. GAAP.  Therefore, employee lawsuits, environmental claims, unresolved income tax audits, and other claims against the debtor company are typically not recorded on the balance sheet.

Unlike the GAAP-based balance sheet, the Asset-based Approach value-based balance sheet recognizes the current value of: 1) all of the company’s assets (both tangible and intangible) and 2) all of the company’s liabilities (both recorded and contingent).

To conclude the defined value for the company’s assets and liabilities (whether individually or collectively), the analyst applies generally accepted asset (and liability) valuation methods.  These valuation methods are categorized into the three categories of generally accepted property valuation approaches: the Income Approach, the Market Approach, and the Cost Approach.

When to Apply the Asset-based Approach

Under most professional business valuation standards, the analyst should consider all generally accepted valuation approaches.  Therefore, the relevant question is not: when should I perform the Asset-based Approach?  Rather, the relevant question should be: when can I not perform the Asset-based Approach?  As a general principle, the Asset-based Approach should at least be considered (if not completed) in every business valuation assignment.  The reasons why an Asset-based Approach analysis is not performed should be described in the valuation report.  And, the reasons should be substantive and not perfunctory.  That is, a mention that “the subject company is an operating company” may not be a sufficient explanation.

The analyst’s selection of applicable valuation approaches is a function of four primary factors: 1) the type of subject company, 2) the type of subject business interest, 3) the type of subject transaction, and 4) the availability of necessary data.

Some analysts believe that the Asset-based Approach is only applicable to so-called asset-intensive companies.  This conclusion is technically correct.  However, this conclusion ignores the reality that virtually every company is an asset-intensive company.  The fact is that the Asset-based Approach is applicable to tangible-asset-intensive companies—and to intangible-asset-intensive companies.  Virtually all companies are either tangible-asset-intensive or intangible-asset-intensive (or a combination of both asset types).  Therefore, the Asset-based Approach is applicable to most types of companies.

Some analysts also believe that the Asset-based Approach is only applicable to so-called asset holding companies.  In fact, this approach is applicable to any company that owns assets.  So, the Asset-based Approach may apply in the valuation of asset holding companies, and it may apply in the valuation of asset operating companies.  Just about every company falls into one (or both) of these two categories.  Therefore, for analysts who know how to perform asset valuations on a going-concern premise of value basis, the Asset-based Approach is applicable to most types of companies.

The type of valuation subject influences the selection of the valuation approach.  The Asset-based Approach (without adjustment) typically concludes a controlling, marketable ownership interest level of value.  This approach is particularly applicable to the valuation of an overall business enterprise—a valuation objective that often relates to a business purchase or sale transaction.  This valuation approach is not as applicable to the valuation of a noncontrolling, nonmarketable block of nonvoting common stock—a valuation objective that often relates to a tax planning, compliance, or controversy assignment.

The type of the transaction (or the type of the assignment) influences the selection of the valuation approach.  The valuation of an overall business is well served by the asset-based valuation approach.  This approach is particularly applicable to a company merger and acquisition analysis, a stock exchange ratio analysis, a fairness opinion, a solvency opinion, or any other transaction involving the overall business enterprise.

This valuation approach is applicable to a company acquisition that is structured as an asset purchase transaction (as compared to a stock purchase transaction).  This is because the deal price is directly related to the value of the company tangible and intangible assets.  The Asset-based Approach is applicable to any transaction that is structured as a taxable transaction (as compared to a nontaxable transaction).  This is because the deal price will depend on the prospective depreciation and amortization expense and income tax rates associated with the revalued tax basis of the transferred assets.  This valuation approach is applicable for asset-based secured financing purposes.  In such an instance, different creditors could have different claims on different debtor asset classes.  And, this approach is applicable for various taxation-related assignments, such as a company conversion from C corporation tax status to S corporation tax status.

The quantity and quality of available data affects the selection of the valuation approach.  The fact that there are no sufficiently comparable publicly traded companies in the subject industry sector affects the analyst’s ability to apply the market approach guideline publicly traded company method.  The fact that there is no prospective financial information in existence at the subject company affects the analyst’s ability to apply the Income Approach discounted cash flow method.  If the analyst has no access to company asset-specific information (e.g., no available information regarding the company’s individual tangible assets or intangible assets), this fact will affect the analyst’s ability to apply the Asset-based Approach asset accumulation (AA) method.

Likewise, if the analyst is working for the outside party in a transaction or a litigation proceeding, this fact may affect the analyst’s ability to obtain sufficient data (or sufficient asset access) to apply the AA accumulation method.  And, if the valuation is retrospective—and all of the company’s tangible and intangible assets have materially changed since the valuation date—this fact may affect the analyst’s ability to apply the AA method.

The above-mentioned data limitations primarily relate to the AA method.  Asset-specific data limitations, asset access limitations, and retrospective valuation dates are less important in the application of the adjusted net asset value (ANAV) method.  Data issues may affect the analyst’s selection of which Asset-based Approach valuation method to apply.  Data issues do not necessarily eliminate the application of the Asset-based Approach.

The most relevant reasons why analysts do not apply the asset-based valuation approach are: 1) there are additional costs and time requirements associated with this approach, and 2) many audiences for valuations (including boards of directors, shareholders, bankers, legal counsel, and judicial finders of fact) are not as familiar with asset-based valuation analyses.

Summary

This discussion provided an introduction to analyst considerations regarding the application of the Asset-based Approach to value both asset-holding companies and operating companies.  The next discussion in this series will consider common misconceptions regarding the application of the asset-based business valuation approach.  Future discussions in this series will describe and illustrate two common Asset-based Approach methods: 1) the AA method, and 2) the ANAV method.

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.