Determining the value of a business is an essential exercise for many reasons.
In most cases, a valuation is conducted because the business is involved in a sale or acquisition. In other cases, determining a company’s value is needed for shareholder buy-ins, estate planning or for litigation, such as divorce cases. For most business owners, a business valuation will be conducted one or two times during the tenure of their ownership. Thus, many are unfamiliar with how valuations are conducted and the various approaches that can be taken. Depending on the type of business, industry served and financial facts and circumstances, a valuation professional can use one of three approaches – or a combination of them all – including the asset approach (also called the cost approach). This approach is generally used to determine the value of a non-operating business or one that is generating losses. To help clients, prospects and others understand the asset approach, Hanson & Co. has provided a summary below.
What is the Asset Approach?
This approach measures the current market value of a company’s assets subtracted from its liabilities to determine the value of a business. As part of their analysis, valuation professionals need to determine which of the company’s assets and liabilities should be evaluated and how to measure each. Depending on the size of the company, this can be challenging. It requires vision beyond the balance sheet as a company may not think of certain business factors as assets, such as internally developed products or innovative business methods, which can certainly impact value. This approach is commonly used for operating companies, those with negative revenue or those experiencing liquidation.
Asset Approach Methods
When using this approach, there are two primary methods for determining a company’s value, which include:
Asset Accumulation Method – This method is mainly used to value companies with a significant number of assets and earnings that don’t support a value greater than the value of tangible assets. Examples of such companies may include real estate holding or oil and gas companies. It uses the sum of the listed tangible assets and liabilities listed on the balance sheet with the goal of arriving at a total value based on the value of individual assets. A step up or discount must be applied to account for the cost to obtain similar assets in current market conditions. Finally, the intangible assets (e.g., strategic partnerships and intellectual property) and liabilities (e.g., pending litigation or tax obligations) of a company are considered and a final value assigned.
Capitalized Excess Earnings Method – This method is also known as the Treasury Method because it was introduced by the Department of the Treasury in the 1920’s to determine the value of a company’s goodwill. The basic concept behind this method is that it seeks to determine the value of a company beyond its tangible assets by separating and assigning a value to its intangible assets. It arrives at a value by determining income produced by tangible assets and adds it to the value of intangible assets. It’s important to note that this method is rarely used because of the subjective nature of determining intangible asset value and recent criticism in several court rulings.
Business valuations are complex, and the approach used is based on several factors beyond just business size and type. For this reason, it’s important to consultant with an experienced provider who can identify the most appropriate method for your situation. If you are thinking about selling your company or need a valuation for other reasons, Hanson & Co. can help! For additional information call us at (303) 388-1010, or click here to contact us. We look forward to speaking with you soon.