Asset-Based Valuation - Methods, Pros & Cons

jaro education
3, July 2023
2:03 am

India’s investment banking market has been expanding quickly, which has helped the nation’s GDP to expand at high rates and opened up new job opportunities.

Asset based valuation is one of its prime models that concentrates on the worth of a company’s assets or the fair market value of its total assets after subtracting liabilities. The fair market value of an asset is calculated after it has been evaluated.

To get an in-depth understanding of this model, let’s move further.

What is Asset-Based Valuation?

The asset based valuation model is a framework that determines the fair market value of a firm’s assets. These assets, encompassing tangible elements like property, plant, and equipment, alongside intangible components like copyrights and trademarks, play a pivotal role in generating revenue.

Underlying this model is the principle that the company’s overall equity value equals the total value of its assets, both tangible and intangible, subtracted by its total liabilities, recorded or contingent. Analysts employ diverse techniques to evaluate asset value, including balance sheet values, replacement values, and fair market values.

This widely accepted valuation approach combines flexibility and complexity. Its flexibility emerges from the incorporation of off-balance-sheet items, such as contingent assets or liabilities. Determining the market value of tangible assets based on book value follows a relatively straightforward path. Assessing the worth of intangible assets introduces intricacy, demanding more extensive data, analytical effort, and associated expenses compared to alternative valuation methods.

Asset-Based Valuation Methods

When evaluating the worth of a business, asset-based valuation methods provide a comprehensive analysis of its net asset value and liabilities. Let’s explore two well-known approaches to valuation: the asset accumulation method and the excess earnings valuation method.

The asset accumulation valuation method

is similar to the balance sheet equation. It determines the company’s equity value or net worth by calculating the difference between its assets and liabilities. It considers all assets and liabilities, even those that are not explicitly listed on the balance sheet. For example, it considers the values of intangible assets and contingent liabilities disclosed in financial statement footnotes.

The Excess Earnings Valuation method

is a hybrid approach that takes into account both income and assets when determining the value of a company. This method is particularly useful for valuing the goodwill of a firm, as it utilizes earning as an input and applies the income method to calculate the goodwill. Due to its effectiveness in assessing firms with substantial goodwill, analysts often prefer using the Excess Earnings Valuation method.

Pros & Cons of Asset-Based Valuation

Understanding the pros and cons of asset-based valuation is essential for evaluating the strengths and limitations of this method in determining the value of a company. Below are the prominent pros and cons related to asset-based valuation.

Pros

Uncovering Liquidation Value

Asset-based valuation proves particularly advantageous when a company grapples with liquidation concerns. It provides an estimate of the value achievable through the sale of the company’s assets.

Evaluating Investments

This valuation approach finds relevance in assessing the worth of firms within the investment sector. It aids investors in evaluating a company’s asset value and making well-informed investment choices.

Flexibility in Asset Selection

Asset-based valuation grants the flexibility to choose which assets and liabilities to include in the valuation process. Moreover, it allows for various methods of measuring the value of each individual asset.

Applicability to Equity and Enterprise Value

This valuation method applies to the calculation of both equity value and enterprise value, as long as equity is not involved.

Cons

Neglecting Potential Earnings

Unlike other widely-used valuation methods, asset-based valuation disregards the prospective earnings of a firm. It solely focuses on tangible assets and liabilities, overlooking the potential for future income.

Discrepancies in Asset Value

The value derived from asset-based valuation may not accurately reflect the actual worth a business can attain when disposing of its assets. Real-world market conditions and other factors can impact the realized value of the assets.

Challenges with Off-Balance Sheet Items

Asset-based valuation may require consideration of off-balance sheet items, adding complexity to the measurement of those items. This introduces intricacies in the valuation process.

Demand for Expertise and Precision

Asset-based valuation may appear straightforward on the surface. But achieving an accurate assessment demands a high level of experience, precision, and attention to detail. Without proper data and expertise, companies may struggle to obtain a reliable valuation.

Conclusion

While various methods exist to value a business, asset based valuation is often preferred in situations involving liquidity challenges or in core sectors like real estate. Nonetheless, it comes with complexities, particularly for those with limited experience.

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