To determine the fair market value of a business or business interest, business valuation professionals use three approaches. The first approach is the income approach which derives value from the business’ future earnings. The second approach, the market approach, relies on comparable business transactions to estimate value. The last approach is the asset, or cost, approach which converts the book values reported on the business’ financial statements to their respective fair market values.
The asset approach to business valuation isn’t right for every situation, however, it should be considered in comprehensive valuation. Take a closer look at how valuators apply this technique when appropriate.
Book Value Vs. Fair Market Value
The balance sheet — which shows a business’ assets and liabilities — is a logical starting point for valuing certain types of businesses. However, the amounts reported may not reflect fair market value to a hypothetical buyer or seller for three main reasons:
1. Historical cost under GAAP. Under U.S. Generally Accepted Accounting Principles (GAAP), assets are often recorded at historical cost. Over time, historical cost may understate market value for appreciable assets, such as certain investments and real estate.
2. Cash- or tax-basis accounting. Private businesses that don’t follow GAAP may exclude accruals (such as accounts receivable and payable) and rely on accelerated depreciation methods that understate the market value of equipment, vehicles, and other fixed assets.
3. Unreported items. Internally generated intangible assets — such as customer lists, brands, and goodwill — are generally excluded from balance sheets unless they were acquired from a third party. Balance sheets also might not include contingent liabilities, such as pending litigation or an IRS audit.
Under the asset approach, it’s important to identify all the business’ assets and liabilities, including those that aren’t recorded on the balance sheet. This process often requires significant time and effort. In addition, revaluing certain assets — such as machinery, equipment, and real estate — may require separate appraisals by outside specialists.
Practical Applications
The asset approach is sometimes appropriate because the concept is relatively easy to understand. It may be relevant for asset-holding companies and businesses that rely heavily on their “hard” assets, especially when liquidation is imminent. It may also be useful when the parties present conflicting valuation evidence in litigation.
In addition, the asset approach can serve as a reasonable check for values derived under the income or market approaches. After all, unless they’re under duress to sell, informed sellers typically won’t accept less than net asset value.
Buyers and sellers may sometimes turn to the asset approach in mergers and acquisitions because it assigns a specific value to the individual assets and liabilities that are owned by the business. That’s different from either the income or market approach, which typically estimates the value of the entire business (or business interest).
The asset approach can help the buyer and seller decide exactly which assets and liabilities to include in (or exclude from) the transaction, allowing them to more effectively negotiate a price in a deal structured as an asset sale. After closing, this analysis can be used to allocate the business’s purchase price for tax and accounting purposes.
For More Information
The asset approach to business valuation may receive limited or no weight for many operating businesses if earnings, cash flow, goodwill, or other intangible assets are the primary drivers of value. But don’t underestimate its usefulness — under the right circumstances, the asset approach can unlock essential valuation insights. Contact us to discuss its pros and cons. We can answer any questions you might have about this approach and other valuation techniques.
