(Part 4 of 4)
In part three of our series on the valuation process, we discussed the market approach, one of three approaches available to a valuation analyst as they determine the value of a company or partial interest in the company. Our final communication in this series addresses the third valuation approach, the asset approach, and the specific methodologies within it.
The asset approach is defined by the International Glossary of Business Valuation Terms (“Glossary”) as a general way of determining a value indication of a business, business ownership interest or security using one or more methods based on the value of assets minus liabilities. Under this approach, the valuation analyst adjusts the value of the assets and liabilities (both reported and not reported) of the business from their stated values to the chosen standard of value for the engagement, i.e. fair market value.
In applying an asset approach, the valuation analyst must make an assumption about the operational premise of value for the business. The operational premise of value is an assumption regarding the most likely set of transactional circumstances that are applicable to the business being valued. Two of the general premises utilized are going concern, meaning the business is expected to operate indefinitely into the future, and liquidation, meaning the business should be shut down and the assets disposed of in either an orderly or forced manner.
This approach is typically used in connection with a business that has a heavy concentration of assets, e.g. real estate or investment holding companies. In addition, this approach is often utilized in situations where the earnings of a business are insufficient and do not provide a reasonable return on assets.
One of the more popular methods within this approach is the adjusted net asset method. This method is defined by the Glossary as a method whereby all assets and liabilities — including off-balance sheet, intangible and contingent — are adjusted to their fair market values. Under this method, all assets and liabilities of the subject company are identified and adjusted from their stated values to their fair market values. The adjustments considered are dependent on the “premise of value” chosen for the valuation.
One challenge that often accompanies the application of an asset approach is the identification of off-balance sheet assets and liabilities/contingencies. Under Generally Accepted Accounting Principles and the various U.S. Treasury regulations that guide income tax reporting, there are varying definitions for what is and what is not reported on a balance sheet.
For instance, neither set of these “accounting rules” requires a business to record their own internally generated goodwill, an intangible asset of the business. Thus a subject company’s balance sheet will not include any amount for internally generated goodwill, only goodwill purchased from a third party. In order to appropriately apply an asset approach, this goodwill would need to be valued and included with the other reported assets. This same issue exists for unreported liabilities or contingencies, e.g. a long-term operating lease obligation.
Use of the asset approach often requires the assistance of other appraisers. Real estate, machinery and equipment appraisers can be very helpful in determining the specific fair market value of assets held by the subject business. In addition, it often requires the use of other valuation methodologies and therefore can be a more cumbersome valuation approach if you are already applying an income and/or market approach.
For more questions about how to determine the value of your business, call Jason Thompson at (317) 608-6694 or email [email protected].