If you’re planning to sell your business, you’ll want to ensure you get the most accurate and fair price, which requires a solid understanding of the value of your assets.
In this blog post, I’ll walk you through the different methods of asset valuation to help you better understand the process and maximize the value of your business.
Let’s get started.
What is Asset Based Valuation?
Asset based valuation is a method of determining the value of a business or company based on its assets. In this method, the total value of a company is calculated by adding up the value of its assets, such as property, equipment, inventory, and cash, and subtracting any liabilities, such as loans or outstanding debts.
This method is typically used when a company has significant tangible assets, such as real estate, machinery, or equipment. It can also be useful when valuing intangible assets such as patents, copyrights, and trademarks.
Asset based valuation is one of the three primary valuation methods, along with the market approach and the income approach. The market approach compares the value of the business to similar companies that have sold in the market, while the income approach uses the expected future earnings of the business to arrive at a present value.
Types of Assets
Before we dig into the details, it’s worth taking a minute to walk through the different types of assets that your business might have.
There are two main categories of assets: tangible and intangible.
Tangible assets
Tangible assets include physical items such as buildings, land, machinery, and equipment. These types of assets can be easily valued since their worth is determined by the market value of the item.
Intangible assets
An Intangible asset, on the other hand, include non-physical items like patents, trademarks, copyrights, and goodwill. The identification and proper valuation of these assets are essential to determining the overall value of your business.
For example, if you own a manufacturing company, your tangible assets may include the machinery used to produce goods, the buildings housing the equipment, and the inventory of raw materials and finished products. Your intangible assets may include patents on certain manufacturing processes, a recognizable brand name, and a loyal customer base.
When to Use Asset Based Valuation Methods
Asset-based valuation is particularly useful in the following situations:
Valuing Companies with Significant Tangible Assets
If a company has significant tangible assets such as real estate, machinery, or equipment, an asset-based valuation is often the most appropriate method to use.
In this scenario, the value of the company’s tangible assets is subtracted from its total liabilities to arrive at the net asset value (NAV). The NAV represents the total value of the company’s assets that can be used to pay off its liabilities.
Valuing Companies with Few or No Intangible Assets
If a company has few or no intangible assets, an asset-based valuation is usually the most accurate method. In this case, the value of the company’s tangible assets is added together to arrive at the total value of the company. This method assumes that the company’s value is tied to the value of its physical assets.
Valuing Distressed Companies
Asset based valuation is also useful in valuing distressed companies that have negative earnings or cash flows. In these situations, traditional valuation methods such as the income or market approach might not make sense.
Instead, the focus is on the value of the company’s tangible assets, as they may be the only assets that have value.
Declining Industry with Uncertain Earnings Potential
The asset valuation method can be particularly useful when a company is in a declining industry and its future earnings potential is unclear. In these cases, the value of the company’s assets, such as property, plant, and equipment, may be more reliable indicators of its value than projections of future earnings.
By using the asset valuation method, investors can assess the value of the company’s tangible assets and determine whether they would be able to recover their investment in the event of a liquidation or sale of the company.
Determining Market Value for Liquidation
When a company is being liquidated, the asset valuation method is often used to determine the value of its individual assets. In such cases, it is important to determine the market value of each asset, including inventory, machinery, and real estate, in order to arrive at an accurate valuation of the company as a whole.
The asset valuation method allows investors to assess the value of each asset and make informed decisions about the price they are willing to pay for the company or its individual assets.
Company with a High Debt-to-Asset Ratio
When a company has a high debt-to-asset ratio, other valuation methods may be less accurate because they rely on projections of future earnings or cash flows, which may be impacted by the company’s debt load.
In these cases, the asset valuation method may be more reliable because it looks at the value of the company’s tangible assets instead of its future cash flows.
The asset valuation method allows investors to assess the company’s net worth and determine whether it is a good investment opportunity, even if its debt load is high.
Example of Asset Based Valuation Method
Let’s walk through a scenario to make this real. Let’s say you own and operate a manufacturing company that produces furniture. The company owns a large factory building, various equipment, inventory, and a fleet of trucks used for delivery. To determine the value of the company, you’d first estimate the fair market value of each asset, including the factory building, equipment, and inventory.
Suppose the fair market value of all tangible fixed assets is $10 million. At this point, you’d add the value of any intangible assets, such as patents, trademarks, and goodwill. Suppose the total value of intangible assets is $2 million. In that case, the total value of the company would be $12 million under the asset-based valuation method.
Remember this doesn’t take into account the company’s earnings or future growth potential. If the company had a strong growth potential or a significant amount of intangible assets, the asset-based valuation might not be the most appropriate method.
Asset Based Valuation Methods
1. Asset Accumulation Method
The asset accumulation method is an approach that estimates the value of a company by adding up the fair market value of its total assets, both tangible and intangible. This method assumes that the total value of a business is equal to the sum of all of its parts.
Under an asset accumulation valuation, you’d identify and value each asset, including real estate, equipment, inventory, accounts receivable, patents, trademarks, and other intangible assets. You’d then adds up the fair market value of all these assets to determine the total value of the business.
This method factors in all assets and liabilities, beyond what might show up on a balance sheet (think intangible assets like intellectual property, brand reputation, customer lists etc.)
2. Excess Earnings Valuation
Excess earnings valuation is a method used to value a business based on the premise that a company’s value is not only a function of its tangible assets but also its ability to generate excess profits over and above what would be considered a reasonable return on those assets.
Under the excess earnings method, the value of a business is determined by estimating the fair market value of its tangible assets and then adding the present value of its intangible assets (e.g. goodwill, customer relationships, brand recognition, and other non-physical assets). The excess earnings are calculated by subtracting a fair return on the tangible assets from the actual earnings of the business.
The excess earnings are then multiplied by a capitalization factor, which represents the number of years the excess earnings are expected to continue. The resulting figure is added to the value of the tangible assets to arrive at the total value of the business.
The excess earnings valuation method is commonly used for businesses that have a significant amount of intangible assets and those that generate substantial excess earnings. With this said, the method requires a high degree of judgment and is subject to estimation errors, particularly when estimating the capitalization factor.
Selecting the Appropriate Valuation Method
Selecting the appropriate valuation method requires thought around the type of assets being valued, their unique characteristics, and the purpose of the valuation. In some cases, a combination of two or more methods may be necessary to arrive at a more accurate valuation.
For example, if you are selling a technology company, you may use the income approach to value the company’s patents and intellectual property, the market approach to value its real estate holdings, and the asset approach to value its tangible assets.
It’s important to remember that each method has its own strengths and limitations.
For a quick rule of thumb: the cost approach is most useful for tangible assets, while the market approach is suitable for assets that have similar counterparts in the market. On the other hand, income approach is most suitable for intangible assets and relies on future earnings potential.
Conclusion
As we wrap up, an asset based valuation method can be an effective way to determine the precise value at which a company can be sold.
As I mentioned above, this is not a perfect science – often times a combination of methods may be needed to arrive at a more accurate valuation of a business.
If you have questions, it’s worth thinking about working with a professional business valuation expert who can help you accurately assess the value of your company.
This will help ensure that you are able to negotiate a fair price for your business and that you receive the full value of your hard work and investment.
If you’re interested in a deeper dive into valuation, you might find these posts helpful:
- Valuation vs. Appraisal: What are the Key Differences?
- Service Business Valuation: 4 Easy Ways to Value a Service Biz
- Construction Company Valuation: 5 Key Factors
- How Much Does a Business Valuation Cost? Answers to 13 FAQs
- Business Exit Planning: 16 Ways to Prepare Your Business for Sale
- Business Value Drivers: 20 Ways to Boost Your Exit Valuation
- 3 Ways to Increase Your Small Business Valuation Multiple (M&A Arbitrage)
