Explain valuation based on assets and when it is suitable
The idea
Asset-based valuation values a company as the fair value of its assets less its liabilities. It is most useful for companies whose value genuinely resides in identifiable assets - natural resource holdings, property companies, financial firms with marked-to-market books - and for a liquidation scenario, where it sets a floor. It is weakest for companies whose value lies in intangibles the balance sheet does not carry: brands, research capability, network effects, assembled workforce. For such firms the method reliably produces a value far below any defensible estimate, which is information about the method rather than the company.
Formulas
Net asset value
NAV = A − L and V = NAV ÷ S
- NAV
- net asset value
- A
- the fair value of the assets
- L
- the fair value of the liabilities
- V
- the net asset value per share
- S
- the number of shares
Restate assets and liabilities to fair value first. Suits asset-heavy firms, and gives a floor for firms facing liquidation.
A practice question
For which kind of company is asset-based valuation most appropriate?
- A software company whose value lies mainly in its user baseWhy not: The user base is the asset, and it appears nowhere on the balance sheet.
- A property company whose holdings can be individually appraised - correct
- A consumer brand company with high advertising spendingWhy not: The advertising is expensed as incurred, so the brand it builds is never capitalised.
Asset-based valuation adds up what a company owns and then takes away what it owes: Value of equity = Value of assets - Liabilities. It works best when assets can be identified and valued one by one. For example, a property company with ten buildings can add up their appraised values and deduct its debt. It works badly when the value sits in things not on the balance sheet, such as a software company's users or a brand built through advertising.
A harder one
Why does asset-based valuation understate the value of a strong consumer brand company?
- Because brands are written down through amortisation too quicklyWhy not: A purchased brand may be amortised or tested for impairment, but that affects only a brand that was bought. A brand built internally is not on the balance sheet at all.
- Because consumer companies hold almost no tangible assets of valueWhy not: They hold plants, inventory and property. The issue is what is missing alongside them, not that nothing is there.
- Because internally generated intangibles are not carried on the balance sheet - correct
Asset-based valuation starts from balance sheet values: Value = Assets - Liabilities. Under both IFRS and US GAAP, a company cannot list a brand it built itself as an asset, because the advertising spent on it is treated as an expense when paid. Only brands bought in an acquisition appear. So the most valuable asset is missing. For example, a drinks company with plant and stock of $500 million but a brand earning $200 million a year is worth far more than $500 million, yet this method sees only $500 million.
The hardest tier
Zoe Park, an analyst, covers Hollis Print, a profitable publisher whose majority owner has told the board that the company will be wound up in 90 days and its assets sold. Zoe's estimates of equity value are: fair value of assets less liabilities $9.1 million (based on the prices the assets are expected to fetch in the sale), discounted cash flows on continued operation $14.2 million, and a peer P/E multiple applied to earnings $15.0 million. Which estimate is most relevant for shareholders?
- $14.2 million from discounted cash flowsWhy not: This assumes the company keeps operating, which the wind-up rules out. A going-concern value answers a different question from what holders receive when assets are sold.
- $9.1 million from net asset value - correct
- $15.0 million from the peer multipleWhy not: A peer multiple prices a going concern whose earnings continue and inherits the peers' valuation. After a wind-up there are no future earnings to capitalise.
The key fact is that Hollis will be wound up in 90 days and its assets sold. In a wind-up, shareholders receive what is left after debts are paid from the sale: Equity value = Sale value of assets - Liabilities = $9.1 million. The discounted cash flow value of $14.2 million and the peer multiple value of $15.0 million both assume the business keeps operating and earning, which will not happen. Being profitable usually points to earnings-based methods, but here the going-concern value and the break-up value answer different questions, and only the second is available to shareholders. The higher figures cannot be realised.
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