Asset (Cost) Approach:
Value of Assets less Liabilities

Asset/Cost Approach at a Glance

Basic principle: Assets – Liabilities = Equity Value under Asset Approach
However, this approach more than simple arithmetic: assets and liabilities must be carefully defined, adjusted, and analyzed

– Most applicable to asset-intensive companies (manufacturing, holding companies)
– Typically applicable when interest in subject company is a majority interest with the power to liquidate
– Ideal approach when the company is worth more in liquidation than as a going concern

At first glance, it would seem that the Asset Approach is the simplest of all valuation approaches. After all, a basic principle of accounting is that if liabilities are subtracted from assets, the remainder is equity to investors.

However, qualified business appraisers using the Asset Approach must examine all of the components of a business to determine the value of the whole. This may mean adding new accounts to reflect the value of intangible assets (e.g., goodwill) or removing accounts such as liabilities that are not likely to be paid ( e.g., loans from shareholders).

The Asset Approach encompasses three methodologies: liquidation method, net asset value method and the excess earnings method. The liquidation method assumes the company will be liquidated in the near future and determines its estimated liquidation price, including all fees and commissions the actual owner would incur. The net asset value (also called adjusted book value) method makes adjustments to determine the fair market value of the company's assets. The excess earnings method determines the value of a business by subtracting the return generated by tangible assets from the total earnings that the company generates.

The Asset Approach is generally most applicable to asset-intensive businesses, as opposed to service-oriented businesses (which have few tangible assets). Companies with significant amounts of goodwill typically are not good candidates for this approach since it is generally difficult to determine the value of intangible assets and goodwill separately from the value of the company's assets. Examples of potential candidates for the Asset Approach include manufacturing companies, holding companies and companies that may be facing liquidation.

The Asset Approach is also more appropriate for estimating the value of majority interests (which have the power to liquidate the company) as opposed to minority interests (which typically lack this and other powers). A basic assumption of the liquidation method is that an investor would be able to cause a liquidation of the company and is also able to access the funds resulting from that liquidation. If this is not the case, then neither liquidation value nor net asset value is typically relevant.

Valuing a company with the Asset Approach may require the business appraiser to collaborate with other professional appraisers, such as real estate appraisers and/or equipment and machinery appraisers. In some cases, the business valuation appraiser may coordinate the efforts of other appraisers since he or she has the most comprehensive knowledge of the business as a whole.

Adjustments and Analysis

The first step in the Asset Approach is to determine the value of the assets that the Company owns. Cash and cash equivalents are nearly always taken at face value since these are liquid assets that can be used by the company. Accounts receivables should be assessed to determine what is likely to be recovered.

Inventory is another asset that generally requires an adjustment. A qualified appraiser will examine the inventory accounting practices of a business to determine if any adjustments need to be made. Some businesses may have lax practices which do not account for inventory at all, or which may show a balance that is simply carried forward from year to year. Other businesses may be on a LIFO (last in, first out) basis, in which case adjustments may be needed to reflect the higher cost of replacing inventory. The amount of inventory in raw material form, work in process, and finished good form also has an impact on the value of inventory.

The subject company may also own valuable patents or other intellectual property that are not shown on the balance sheet. The company may also carry significant goodwill value. If it is possible to reliably and accurately measure the value of these intangible assets, an adjustment may be warranted to reflect their value to the company, as long as these intangible assets could be sold in the marketplace.

The subject company's machinery and equipment typically needs an appraisal by a qualified equipment appraiser. Many times this can be difficult and sometimes unobtainable given the various circumstances of the subject company and the valuation report. Without an official equipment appraisal, the business appraiser must make an educated estimate of the value of the equipment using information available to them, such as original equipment cost, when the equipment was purchased, and the equipments current operating abilities and conditions.

Assets are only one component in determining the equity value of a business. Another component that needs to be evaluated is the liabilities the company holds.

One example of a liability that may warrant adjustment is loans from shareholders. In many cases, shareholder loans are simply another form of equity investment by shareholders. In this situation, an adjustment may be made to remove this liability.

Other liabilities to outside creditors should also be evaluated. Adjustments may be needed for long-term liabilities that have interest rates that are higher or lower than market interest rates. Adjustments may also be necessary if a liability can be permanently deferred, or if it is likely that the liability would not need to be repaid if the business were sold.

Conclusion

In profitable companies, the Asset Approach will generally lead to the lowest estimate of value compared to the Income and Market Approaches. If the company's value under the Asset Approach is higher than the value determined by the Income and/or Market Approaches (i.e., the company is worth more dead than alive), the company in question may be a candidate for liquidation. Even if the company is not likely to be liquidated, the net asset value may establish a 'floor' value.

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