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The asset-based approach is defined as a general way of determining the value of a business based on the value of its assets net of liabilities. Under this method, all tangible and intangible, recorded and unrecorded assets of the business are identified and reduced by the value of all outstanding liabilities. The two main methods within the asset-based approach typically used in professional business appraisals are the Book Value Method and the Adjusted Net Asset method.
The Book Value Method, within the asset-based approach, allows business appraisers to estimate the value of a business by subtracting the book value of a company’s liabilities from the book value of its assets. Book Value is defined as a value of an asset or liability as it appears on the company’s balance sheet.
Most professional business appraisers agree that this method has several limitations. According to generally accepted accounting principles (GAAP) most assets are typically recorded at historical costs minus accumulated depreciation or cumulative impairment, and may not reflect the current values of the assets. For example, while the book values for working capital accounts, such as inventory or accounts receivable, may closely reflect fair market value, the book values for other items, such as real estate, machinery and equipment, may be far from their fair market value, and may require independent appraisals, particularly if they were acquired many years ago and fully depreciated.
In similar fashion, most long-term liabilities are recorded at the present value of the liability using rates at the time the liability was established. These rates are not revised to show market changes. Additionally, GAAP does not allow the recognition of many valuable assets such as internally developed trademarks, trade names, logos, patents and goodwill.
Therefore, even though this method is often used in buy-sell agreements, a conclusion of value established based on the Book Value Method may exclude or measure incorrectly the value of many assets.
The Adjusted Net Asset Method, within the asset-based approach, allows valuation experts to adjust all assets and liabilities from book value to fair market value, and estimate the value of a business by subtracting the fair market value of a company’s outstanding liabilities from the fair market value of its tangible and intangible, recorded and unrecorded, assets.
This method includes determining the fair market value of trademarks, assembled workforce, and other intangible property. Properly determining fair market values of real estate, machinery and equipment may require independent appraisals.
A reconciliation between book values and fair market values may include adjustments such as removing non-operating assets (excess cash or cash surrender value of life insurance), converting the Last-In, First-Out (LIFO) inventory to the First-In, First-Out (FIFO) inventory, estimating net present value of the deferred income tax liability associated with the built-in gain on LIFO reserve and property, plant and equipment accounts, and adjusting property, machinery and equipment values to reflect fair market values.
The Adjusted Net Asset Method is an appropriate method for estimating the value of non-operating businesses such as a closely-held partnership with large investments in stocks, bonds, or real estate, because the value of the company is closely related to the value of the underlying assets. This method is also applicable when valuing a business that continues to generate losses, when a company's net value based on income or cash flow is lower than its net asset value, or when liquidation is imminent.
An important consideration when using this valuation method is the premise of value, which is an assumption regarding the most likely set of transactional circumstances that may be applicable to the valuation, for example, going concern or liquidation. The Adjusted Net Asset Method, at liquidation value, generally establishes a "floor-value" for setting total value of the business. This "floor value" is used by business valuation experts to judge the reasonableness of the values indicated by the income and market valuation approaches discussed below.
To read about the Three Main Approaches to Value a Business click here.
Bibliography
AICPA, ASA, CICBV, NACVA and IBA (2017). International Glossary of Business Valuation Terms. Retrieved from: ttps://s3.amazonaws.com/web.nacva.com/TL-Website/PDF/Glossary.pdf
Internal Revenue Service (1959). IRS Revenue Ruling 59-60. Valuation of Non-Traded Assets. See a Link to Full Text (PDF)
Aswath Damodaran (2018). The Dark Side of Valuation. Pearson Education.