HOW IS A BUSINESS VALUED?

A THREE-PART SERIES

Part One: The Asset Approach

There is no single formula for determining what a business is worth.

Depending on the company, a valuation may focus on its assets, what similar businesses have sold for, its ability to generate future income, or some combination of the three.

These are generally referred to as the asset approach, market approach, and income approach. Part One examines the asset approach.

What Is the Asset Approach?

At its simplest, the asset approach asks: What does the business own, what is it actually worth, and what does the business owe?

The basic calculation is:

Fair Value of Assets – Liabilities = Business Value

The company’s balance sheet is usually the starting point, but book value is not necessarily economic value. Accounting records may reflect historical cost, depreciation, or other conventions that have little to do with what an asset is worth today.

Equipment may be nearly fully depreciated and still have substantial resale value. Real estate purchased years ago may be worth far more than its recorded cost. Inventory may be obsolete. Receivables may not all be collectible.

Those differences matter.

What Gets Valued?

The analysis generally begins with the assets and liabilities appearing on the balance sheet.

Assets may include cash, receivables, inventory, real estate, machinery, vehicles, investments, patents, trademarks, software, and other identifiable intangible assets.

Each significant item must be considered based on its actual economic value rather than simply accepting the amount in the accounting records.

Liabilities also require review. In addition to recorded debt, a valuation may need to consider taxes, guarantees, pending claims, or other contingent obligations.

When Is the Asset Approach Most Useful?

The asset approach is particularly useful when the assets themselves are a major source of the company’s value.

Examples include real estate holding companies, investment companies, manufacturers with substantial equipment, and other asset-intensive businesses.

It may also become important when earnings are weak or inconsistent. If the company is not generating enough income to support an earnings-based valuation, its underlying assets may provide a better indication of value.

The approach is also commonly considered when a business is being liquidated or is in financial distress.

Going Concern Versus Liquidation

A key question is whether the company is being valued as an operating business or as a collection of assets to be sold.

Under a going-concern premise, the assumption is that the business will continue operating.

A liquidation value considers what could reasonably be recovered if the assets were sold and the liabilities paid.

Even then, timing matters. An orderly sale conducted over time may produce substantially more than a forced sale under financial pressure.

Where the Asset Approach Falls Short

For many service businesses, the balance sheet tells only a small part of the story.

A successful medical practice, consulting firm, law firm, accounting practice, or technology company may own relatively few physical assets while still generating substantial profits.

Its value may instead be tied to goodwill, reputation, intellectual property, workforce, operating systems, or expected future earnings.

In litigation, another issue may arise: whether goodwill belongs to the business itself or is dependent upon the individual owner. That distinction between enterprise goodwill and personal goodwill can materially affect value.

The Bottom Line

The asset approach sounds simple: assets minus liabilities.

In practice, the real work lies in determining what those assets and liabilities are actually worth and whether an asset-based methodology makes economic sense for the particular company.

A balance sheet gives us numbers. A valuation determines what those numbers actually mean.

NEXT: THE MARKET APPROACH

Part Two will examine how comparable businesses and transactions can provide evidence of value.