Asset-Based Valuation: Methods, Formula & Business Examples

Asset-based valuation is a method of determining the actual value of the assets that a company owns, such as property, shares, patents, and brand recognition, along with its debt, called liabilities. We at The Algebra Group help you by providing expert advice on asset-based valuation and compliance with relevant legal standards. Because it is crucial for every investor and regulator to completely recognize the value of their assets for protecting the interests of investors who invest money or for making smart decisions.

What is Asset-Based Valuation?

Definition of Asset-Based Valuation -

The asset-based valuation approach emphasizes measuring business value by calculating the net asset value, obtained after deducting liabilities from assets. This approach is important for individuals interested in comparing values, sales, and liquidations, as it provides flexibility in valuation by considering market values and intangible assets.

Difference Between Asset Valuation and Asset-Based Valuation -

• Asset valuation methods focus on a specific asset or group of assets, such as machinery, buildings, inventory, or a patent. Asset-based valuation focuses on determining the company's total asset value by analyzing total assets and total liabilities.
• Asset valuation is the process of calculating the fair market or current value of assets like stocks, bonds, and tangible or intangible assets. Asset-based valuation is the process of valuing a business by calculating the company’s asset value or the fair market value of its net assets by subtracting liabilities.
• Asset valuation is ideally used in situations of mergers, loan applications, or asset trading. The asset-based valuation approach is used by companies with unclear equity value, as it provides alternative valuation metrics.
• The different methods for asset valuation are the cost method, the market value method, the base stock method, and the standard cost method. The various methods for asset-based valuation are the book value method, liquidation value method, asset accumulation valuation method, net asset value valuation method, and excess earnings valuation method.

Key Components of the Asset-Based Valuation Model -



Tangible Assets: Tangible assets are physically present and can be measured and quantified. It involves machinery, equipment, inventory, cash, real estate property, land, and buildings. Tangible assets are generally valued on the basis of their current fair market value or book value.

Intangible Assets: Assets that are not physically present but uplift the value to the company, such as patents, trademarks, goodwill, copyrights, and brand popularity. Evaluation of these assets is a more challenging task than valuing tangible assets, as they are not physical in nature.

Why is the Asset-Based Valuation Approach Used?

Objectives of Valuation of Assets -

Provide Assistance with Insolvency and Bankruptcy

The asset-based valuation method helps determine the value of the company's assets and debts at the time of a financial crisis. This approach allows inventors, stakeholders, and creditors to figure out whether the company can be saved or has to be closed down or liquidated.

Promotes Business Deals

Asset-based valuation promotes big business actions such as mergers, acquisitions, or share buybacks. It safeguards the interests of all participants by guaranteeing them that all deals take place at fair prices.

Effective Financial Reporting

Indian Accounting Standards mentioned that the company has to present a real representation of their finances in a report. Asset-based valuation guarantees that assets and liabilities are recorded at true value, and this approach promotes trust of investors, stakeholders, and creditors.

Manage Foreign Investment

According to FEMA - Federal Emergency Management Agency, asset-based valuation guarantees that the price at which a nonresident or foreigner purchases or sells securities is fair.

Analyze Loan Values:

Banks and financial institutions use asset-based valuation techniques to determine the worth of a company's assets before granting loans. It is popularly called the loan-to-value ratio, which is regulated under RBI rules.

To Calculate Taxes

Asset-based valuation plays an important role in determining how much tax a company or a person pays, known as capital gains tax. According to the Income Tax Act of 1961, there is a shared method to calculate the fair price of unlisted shares. For instance, if an individual purchases an unlisted share and pays more than the fair value, that extra amount might be taxed and considered as income to stop tax evasion.

When Businesses Prefer the Asset-Based Approach

Businesses with intangible assets widely use the asset-based approach, as it considers economic and operational depreciation. For example, with a company with intangible assets such as outdated technology, this process helps to ensure that the company is still functioning with the obsolete technology, whereas the competitors benefit more from advanced technology. The asset-based valuation method helps to make decisions with the available assets and liabilities.

Situations Where Asset Value Matters More Than Earnings -

At the time of mergers, acquisitions, or buybacks, the asset valuation process is utilized. It also protects the interests of small inventors by ensuring that parties have followed the SEBI guidelines and guarantees that the securities are not sold at an unfair price. Additionally, when a multinational company purchases or sells shares, this process ensures that it has paid a fair price, and it supports managing India's foreign currency reserves.

How Does the Asset-Based Valuation Approach Work?

Understanding the Asset Approach Valuation -

The key responsibility of any financial executive of a company is to determine and maintain a complete understanding of the real value of the company. Generally, if the company's value increases, the return distribution among investors and stakeholders also increases.

There are various methods to determine the company's value, but the two most common methods are equity value and enterprise value. Additionally, an asset-based approach can be used along with these two valuation techniques or also as a separate valuation method.

Equity is required in both the equity value and the enterprise value techniques. If a company does not have equity, analysts can apply the asset-based valuation as an alternative approach to equity.

Stakeholders determine the asset-based value and use it extensively in the comparison of valuations. In some kind of analysis, this technique may also be used by private businesses as extra due diligence. More importantly, this method is widely used by companies that are planning to sell or liquidate.

Total Assets Minus Total Liabilities Concept -

Let's understand the concept of total assets minus total liabilities.

• Assets: It involves cash, cash equivalents, or liquid assets; these are generally treasury bills or certificates of deposit. Additionally, the company's inventory, machinery, buildings, and property are considered as assets. Whereas building machinery and property are kept for the long term.
• Liabilities: Liabilities are the debts and expenses that a company must pay in order to keep running. Debt is a common long-term loan that is due and has to be paid. Whereas expense involves rent, taxes, employee salaries, and dividends payable.
• Total Assets minus Total Liabilities: the value obtained after subtracting total assets and total liabilities is called shareholders' equity. Shareholder equity is the total amount of dollars a company would have left if it sold all its assets and settled all of its debts. It is then finally distributed among the shareholders.
• Shareholder equity also includes retained earnings; it is the sum of total earnings that were not distributed among shareholders as dividends and are set aside or kept for later use. Therefore, consider retained earnings as savings.

Fair Market Value vs. Book Value Adjustments

• To calculate the book value of the company is a rewarding task, but at the same time, it is far more challenging compared to determining the fair market value of the company.
• Buying stocks at lower market values than their book valuation helps investors in creating more wealth.
• The market value is defined by what investors are ready to pay for a company’s stock on the other hand, the book value is identical to the company’s net asset value. The book value fluctuates much less than the stock price of the company.
• Book value refers to the net asset-based valuation of a company, which is shown on its balance sheet, and it is approximately equal to the total amount that each shareholder would receive in case they liquidate the company.
• The market value of the company is based on the total value of its current shares in the market, or by its market capitalization.
• Fair market value is generally higher than the company's book value because it includes various factors such as profitability, intangible assets, and potential for future growth.
• The most common method to compare book value and fair market value is the price-to-book ratio, where a lower value represents a profitable deal.

Asset Approach in Business Valuation

Asset-Based Business Valuation Explained -

Asset-based business valuation is a kind of valuation where the business is focused on measuring the value of the company's assets or the fair market value of its total assets by removing liabilities. Hence, the asset gets evaluated, and the fair market value of the company's asset is identified.

For instance, landowners may collaborate with appraisers to determine the market value of the property. The value of the property increases over a period of time, and hence the landowner may notice that the value of the property is higher than it was five years ago. The updated value is quoted and is used in the asset-based approach. Conversely, liabilities happen at the fair market value. Therefore, asset-based valuation is used to determine the amount of capital required to establish a similar business.

Asset-Based Company Valuation Process -

The asset-based company valuation process involves some steps as below:

• Determine the Assets: Determine the assets that the company owns. It generally includes both tangible and intangible assets. In addition to valuing assets, it is essential to check the financial statements and balance sheet of the company, as it includes a comprehensive list of the company's assets and their values.
• Calculate the Value of Tangible and Intangible Assets: Valuing the tangible assets involves an assessment of the fair market value or book value of each one of them. Whereas assessment of intangible assets is a more complex task than valuing tangible assets, because its future cash flows or cost savings that it will generate are entirely based on prediction. The cost method, or excess earnings method, is ideally used to value intangible assets.
• Measure Total Asset Value: The total value of assets is evaluated by putting together the value of tangible and intangible assets.
• Calculate Net Asset Value: The net asset value is determined by removing the total value of liabilities from the total asset value.

Tangible vs. Intangible Asset Valuation

Tangible Assets	Intangible Assets
• Tangible assets are physically present and can be seen or touched by stakeholders or investors.	• Intangible assets are not physically present and are virtual in nature.
• They help perform the operational activities.	• They play a major role in improving competitive advantage and building brand value.
• The valuation of tangible assets is based on cost, depreciation, and market rates.	• The valuation of intangible assets is based on models of earnings, royalty rates, and market comparison.
• Its depreciation is dependent on the wear and tear of its assets	• They are not ideally physically depreciable but may become less valuable over a period of time.
• Examples are property, inventory, machinery, and equipment.	• Examples are brand value, trademark, goodwill, patent, and copyrights.

Methods of Asset-Based Valuation

1. Book Value Method

This book value method uses the company's past cost accounting in order to determine its total net assets by subtracting liabilities from its assets. The most basic type of asset-based valuation is actually found in the company's balance sheet.

Book Value=Total Assets-Total Liabilities

2. Liquidation Value Method

This method is ideally based on the assumption that the company is liquidated, i.e., all the assets of a company are sold, and liabilities are set off. Liquidation value is defined as the value at which the company can sell its assets in case of forced sale, which is usually lower than the book value because the assets are required to be sold quickly and may be at a discount.

3. Net Asset Value (NAV) Method

The net asset valuation method calculates the value of an asset by deducting total liabilities from total assets. It includes both tangible and intangible assets. This method is mostly preferred under the Income Tax Act, especially for valuing unlisted shares, and under the Companies Act for determining the shareholders' funds.

It is widely used by the industries that rely heavily on assets, like manufacturing or real estate companies.

4. Asset Accumulation Method

In the asset accumulation method, assets and liabilities of a company are gathered, and a value is assigned to each asset and liability. Then the value of the entity is determined by subtracting the asset value from the liability value.

The asset accumulation approach seems to be simple, but it requires an effective process of assigning value to assets and liabilities.

A few of the items that are being valued in the valuation process generally don't appear on standard balance sheets, such as trademarks, patents, and company value. Additionally, some unresolved cases or legal compliance issues are also included in this list.

5. Excess Earnings Method

The excess earnings method is ideally used to determine the company's goodwill, and in addition, it assesses the company's tangible assets and liabilities. Goodwill of the company is calculated by considering the company's earnings as an input and then linking them with the income method. Hence, to calculate the value of a strong business with considerable goodwill, the excess earnings method is extensively preferred.

Asset-Based Valuation Formula and Step-by-Step Calculation

Asset-Based Valuation Formula -

The asset valuation formula determines the net asset value of a company by deducting the fair market value of their tangible and intangible assets from total liabilities.

Net Asset Value (NAV) Formula -

NAV (Net Asset Value)=Total fair market value of assets-Total Liabilities

Step-by-Step Calculation Process -

• The first step is to recognize the assets of a company that it owns. It may include tangible and intangible assets.
• Find out the value of tangible and intangible assets.
• Calculate the value of total assets by adding both tangible and intangible assets.
• In the last step, subtract the total liabilities from the total assets to determine the net asset value.

Adjusting Net Assets for Accurate Business Valuation

Revaluing Fixed Assets -

Revaluation of fixed assets is a business valuation process, also called the adjusted net asset method, that modifies the stated values of company assets and liabilities to more effectively represent their estimated current fair market values.

Adjusting Hidden Liabilities -

The net outcome provides values that can be used in the current assessment or bankruptcy scenarios by adjusting the values of hidden assets or liabilities.

Treatment of Intangible Assets -

This kind of adjustment includes both off-balance sheet assets and unrecorded liabilities like leases or notable commitments. Hence, the adjusted book value of the company is determined by subtracting the total fair market value of adjusted assets from the total fair market value of adjusted liabilities.

Asset-Based Valuation Example (With Calculation)

Sample Company Balance Sheet

Let's take an example of a company holding the following assets and having the mentioned liabilities.

Assets	Value
Property holding	$55400
Equipment and Machines	$27200
Inventory	$10800
Accounts Receivable	$5400
Total Assets	$98800

Liabilities	Value
Long-term debt	$32600
Account Payable	$10800
Total Liabilities	$43400

Step-by-Step Numerical Example

Net Asset Value=Total Asset -Total Liabilities

Net Asset Value=$98800-$43400=$55400

Final Business Valuation Result

$55400 is the estimated business value using the adjusted net asset method.

Asset-Based Valuation vs. Enterprise Value and Equity Value

Asset-Based Valuation vs. Enterprise Value -

The asset-based valuation approach is ideally used to measure the net asset value of a company by deducting total liabilities from total assets. Whereas enterprise value calculates the overall (total) value of a company by using the data available on the company's financial statements.

Asset-Based Valuation vs. Equity Value -

The asset-based value refers to the net asset value of a company calculated by deducting total liabilities from total assets. On the contrary, equity value refers to the value of the company's shares and any loans that the shareholder has provided to the business.

Asset Approach vs. Income and Market Approach -

The asset approach valuation is also referred to as the adjusted asset-based valuation method, calculated by subtracting total assets from total liabilities.

The income and market approach is also referred to as the real estate valuation method, which utilizes the income that the property has earned to calculate the fair value. It is measured by dividing the operating income by the capitalization rate.



Advantages and Limitations of Asset-Based Valuation

Advantages of Asset-Based Valuation

• Easy to Understand and Measure: The main advantage of asset-based valuation is its simple process of identifying and calculating the company's value. Additionally, this process helps investors and stakeholders to investigate and determine the company's value more easily.
• Objective in Nature: This approach is ideally based on assumptions such as future cash flow or earnings; hence, this approach offers more accurate results, especially for companies with predictable and established asset values.
• Offers Reasonable Value for a Company: It offers a fair estimate of company value for those with uncertain future earnings potential. This makes it easy for the investors and stakeholders to understand the foundational value of the company's assets despite relying on its future earning potential.

Limitations and Challenges

• Does Not Evaluate Future Earning Potential: Asset-based valuation mainly focuses on valuing assets of the company and undervalues the actual value of the company, especially when the value of the asset does not fully reflect the future earning potential.
• Overlooks Intangible Assets: The valuation of intangible assets is difficult and is often not reflected in a company's financial statements. This approach overlooks the company's true value, which drives a large portion of their value from intangible assets.
• Fails to Reflect Market Value: The market value of a company is based on the investors' sentiments, industry trends, and economic environment, and not the value of assets. Hence, the asset-based valuation approach fails to reflect the market value of the company.

Common Mistakes in Asset Valuation

• Depend on Past Data: It is a common mistake to fully depend on the company's past information because historical data does not consider future market dynamics or technological advancements.
• Avoid Market Trends: Overlooking current market trends can result in overvaluing or undervaluing company asset value.
• Neglecting Intangible Assets: Overlooking intangible assets such as brand reputation or intellectual property is a common mistake. A brand asset valuation tool helps to verify the brand's potential, thus providing a clear image of the value of the company's intangible assets.

When Should You Use the Asset-Based Valuation Approach?

Best Use Cases

Asset valuation processes play a crucial role in valuing intangible assets such as patents, logos, franchises, goodwill, and trademarks.

For instance, within a single day, an international firm holding an asset worth $20 billion is declared bankrupt and is not left with any tangible assets. The international firm's intangible assets, such as its logo and patents, can still boost the interest of many investors and companies in acquiring it.

Industries Where Asset-Based Valuation Works Best

Asset valuation methodology works best in valuing financially troubled companies. In these types of companies, the future earning potential might be uncertain. Thus, by emphasizing the calculation of the value of the assets of a company, an asset-based valuation approach can determine a more accurate and reliable estimate of a company's value during such tough situations.

When to Avoid This Valuation Method

Asset-based valuation processes should be avoided in circumstances where a company has significant growth potential or for those companies that derive a large amount of value from their ability to produce future cash flows.

Because this process focuses mainly on valuing the assets of a company and underestimates the real value of the company.

Conclusion

The asset-based valuation method provides a basic method to evaluate a business's value by emphasizing the tangible and intangible assets of the company or business. Ideally, this process is more suitable for those companies with a significant amount of physical assets. Additionally, it safeguards the interests of inventors, stakeholders, and owners of the company by following the best global practices. We at TAG offer assistance in valuing your assets under Indian law.