Most Appropriate for Asset-heavy Companies with Tight Margins

Key Takeaways:
  • The asset-based approach is ideal for valuing asset-heavy companies with tight margins, such as farms and construction companies, by focusing on their net asset value minus liabilities.
  • The adjusted net asset method enhances accuracy by revaluing assets and liabilities to their current market values, providing a clear picture of a company’s worth independent of income generation.
  • While straightforward and objective, the asset-based approach overlooks future earnings potential and intangible assets, making it less suitable for service-oriented businesses.

 

Business valuations can be done using any one of several different approaches, and valuation professionals carefully consider the goals of a business owner and the financial and operational condition of the business before selecting an approach. In some cases, a combination of approaches can be employed to reach the most accurate conclusion. 

The asset approach is the go-to approach for use in a business valuation that focuses on a company’s net asset value when there is very little to no goodwill or intangible assets to consider. The asset approach (or asset-based approach) is based on the premise that a company’s value can be derived from the total value of its underlying assets, minus its liabilities. This method is particularly useful when valuing companies that are asset-intensive – such as farms and construction companies – or in cases where the business is being liquidated. It is also commonly used for holding companies, distressed businesses and businesses with a lack of income or cash flow that cannot be normalized. 

Business entities with significant and, in many cases, valuable physical assets may not necessarily generate a large return on investment, making the income-based approach and the market-based approach inappropriate for valuation purposes. Farmland is one example where there is high capital appreciation in the value of the land. However, farm rents and income generation may not be particularly strong. So the highest indication of value on a farm or an entity that holds a lot of farmland will be reached with the asset-based approach. 

Other asset-intensive businesses for which we often use the asset-based approach include construction companies, which own heavy machinery and have tight margins, depending on market conditions. In valuations of these types of companies, the owners must obtain a separate appraisal of their equipment to support the valuation. 

Additionally, the asset-based approach is commonly used for distressed companies, those that are experiencing consistently low earnings or losses and which may be on the brink of being sold or liquidated.  

The primary method within the asset approach is the adjusted net asset method. 

Adjusted Net Asset Method 

The adjusted net asset method provides a more accurate reflection of the company’s value by adjusting the book values of assets and liabilities to their current fair market values. This method involves: 

  • Identifying all assets and liabilities: A thorough examination of the company’s balance sheet to list all assets and liabilities. This includes tangible assets like property, equipment and inventory, as well as intangible assets like patents, trademarks and goodwill. 
  • Revaluing assets and liabilities: Adjusting the book values of these assets and liabilities to their current market values. This may involve market research, appraisals and the application of depreciation and obsolescence adjustments. 
  • Calculating net asset value: Subtracting the total adjusted liabilities from the total adjusted assets to arrive at the net asset value (NAV).  

Application in Practice 

The practical application of the asset approach involves several steps: 

  • Asset Inventory: Conducting a comprehensive inventory of all assets, including tangible and intangible items. 
  • Valuation Adjustments: Adjusting the book values to reflect fair market values. This might require professional appraisals, particularly for real estate, mineral interests, and equipment. 
  • Considering Off-Balance Sheet Assets or Liabilities: If the company is currently a party named in a litigation case, there could be some exposure to a future adverse claim. This is just one example of a potential off-balance sheet adjustment that an appraiser needs to consider. Depending on what is known or knowable as of the valuation date will determine the potential adjustment. 
  • Net Asset Calculation: Subtracting total adjusted liabilities from total adjusted assets to determine the NAV. 

Example: Consider a manufacturing company with substantial physical assets, including factories, machinery and inventory. By revaluing these assets to their current market value and subtracting outstanding liabilities, the asset approach can provide a clear picture of the company’s value independent of its income-generating capacity. 

It’s important to note that the asset-based approach does not take into consideration any intangible assets such as goodwill. While intangible assets may be noted during the gathering of data, they are not accounted for in the final valuation. 

Advantages and Limitations 

As with other valuation approaches, the asset-based approach has both advantages and limitations: 

  • Advantages include simplicity, objectivity and relevance for certain types of companies. 
  • Limitations include that the asset-based approach ignores future earnings potential, it relies on current market values of certain assets, requiring third-party appraisals and the approach is not applicable to service-oriented companies because it does not adequately capture the value of human capital, brand and other intangibles. 

If you would like to discuss a valuation of your business, your interest in a company or your personal property for estate planning purposes, contact an Adams Brown advisor.