Chapter 6 Asset-Based Approach Valuation Methods

• Jurisdiction: United States

Chapter 6: Asset-Based Approach Valuation Methods

A. The Asset-Based Approach to Business valuation

Although less commonly applied than the income approach or the market approach, the asset-based approach is a generally accepted business valuation approach and is described in most comprehensive business valuation textbooks. In addition, consideration of the asset-based approach is required by most authoritative business valuation professional standards. For example, professional standards such as the American Institute of Certified Public Accountants' (AICPA) Statement on Standards for Valuation Services (SSVS) and the Uniform Standards of Professional Appraisal Practice (USPAP) require the analyst to consider the application of the asset-based approach. That is to say, such professional standards require the consideration of — but not necessarily the application of — the asset-based approach. In practice, however, many analysts immediately reject the use of asset-based approach methods in a bankruptcy-related business valuation as being too difficult, too time-consuming, too client-disruptive, or simply (and without adequate explanation) not applicable to the subject debtor company.

In truth, many analysts do not seriously consider using the asset-based approach in the typical bankruptcy-related business valuation. This is because these analysts are not sufficiently familiar with the generally accepted methods and procedures within this business valuation approach. In addition, many analysts labor under misconceptions about when — and when not — to apply this valuation approach, and many analysts also hold misconceptions about interpreting the quantitative results of the asset-based valuation approach. Hopefully, this section will correct many of the common misconceptions about this business valuation approach — particularly with regard to the valuation of debtor companies within a bankruptcy environment.

As will be discussed below, the proper application of this business valuation approach requires a slightly different set of skills than does the application of the income approach or the market approach. Not all analysts have the experience or expertise to perform a comprehensive asset-based approach business valuation analysis. In addition, it is true that the completion of the asset-based approach often requires more analyst time than other business valuation approaches. That additional analyst time typically translates into additional professional fees charged to the bankruptcy engagement client. Therefore, bankruptcy engagement clients often discourage the use of the asset-based approach when they come to learn about both the additional elapsed time and the additional costs associated with this particular valuation analysis. Furthermore, the successful performance of this valuation approach often requires more data from — and more involvement by — the subject debtor company executives. Again, when these additional commitments are understood, many clients may discourage the use of the asset-based approach.

Finally, in the typical bankruptcy controversy-related business valuation assignment (which could include issues related to preferance payments, fraudulent transfers, and credit protection, among others), the analyst may not be granted sufficient access to the debtor company's facilities or executives in order to practically implement this valuation approach. Also, particularly in a retrospective controversy-related assignment, the debtor company data that the analyst needs — and the debtor company personnel that the analyst needs access to — are simply no longer available. In many of these bankruptcy-related instances, it may simply be impractical for the analyst to perform some asset-based approach valuation methods.

This section is the first of three sections related to the application of the asset-based business valuation approach within a bankruptcy environment. This first section describes the theory and general application of the asset-based approach. The second section describes and illustrates a common asset-based approach valuation method: the asset-accumulation (AA) method. The AA method involves the identification and valuation of each individual category of the debtor company's assets (both tangible and intangible). The final section describes and illustrates the adjusted net asset value (ANAV) method. The ANAV method involves a single aggregate relocation of all of the debtor company's total collective assets.

Theory of the Asset-Based Approach

The asset-based approach is sometimes called the asset approach to business valuation. Either term is generally accepted among valuation analysts and in the valuation literature. The asset-based approach encompasses a set of methods that value the debtor company by reference to its balance sheet. In contrast, income-approach and market-approach valuation methods focus on the debtor company's income statement and/or cash flow statement.

One of the very first procedures in any business valuation is to define the business ownership interest subject to valuation. That is, the assignment should specify whether the valuation intended to conclude a defined value for the debtor company's:

1. total assets;
2. total long-term interest-bearing debt and total owners' equity;
3. total owners' equity; or
4. one particular class of owners' equity.

Each of the above descriptions is a valid objective of a business valuation, and each conclusion is often referred to as a "business value." Yet obviously, each of these business-value conclusions will be quantitatively different for the same debtor company. Also, each of these business-value conclusions will be perfectly appropriate in the right circumstance — usually based on the actual or hypothetical transaction that is being analyzed.

Knowing the debtor company's total asset value is necessary in an acquisition structured as an asset purchase (instead of as a stock purchase). The company's total invested capital (TIC) — often called the market value of invested capital (or MVIC) — is the value of all long-term debt plus all classes of owners' equity. Knowing the value of the TIC is important in a deal structure where the buyer will both acquire all of the company's equity and assume all of the company's debt. Knowing the value of the total owners' equity is important when only the company's equity securities (say, all common stock and all preferred stock) are at issue in the transaction. In addition, knowing the value of one particular class of equity only (say, only the company's common stock) is important when only that class of security is the subject of the proposed transaction.

In any event, the asset-based approach is based on the premise that the value of the debtor company is equal to the value of the company's total assets minus the value of the company's total liabilities. If properly applied, this valuation formula can be used to indicate the value of any of the valuation objectives listed above. Of course, there are two particularly important words in the above valuation formula: "value" and "total."

The asset-based approach is based on the value of (not the recorded balance of) the debtor company's assets and liabilities. The standard of value in the analysis has to be defined, as does the valuation date of the analysis. The standard of value is determined by the assignment. Common standards of value for bankruptcy-related purposes include fair market value and fair value. Other common standards of value include investment value, owner value, use value and user value. Whatever the assignment-specific standard of value is, the value conclusion is likely going to be different from the recorded account balances presented on the subject company's balance sheet. Those balance sheet recorded account balances are probably being presented in compliance with generally accepted accounting principles (GAAP), which typically include a combination of historical cost-based measures and GAAP-based fair value measures.

The asset-based approach is also based on the total of all of the debtor company's assets and liabilities. GAAP-based balance sheets typically exclude major categories of com- pany assets and company liabilities. For example, GAAP-based balance sheets do not record most internally created intangible assets. In the information age, such intangible-asset categories often represent the major sources of value for any subject business entity. This statement is obvious for technology-related entities, but it is also true for most debtor companies. Under U.S. GAAP, the values of an entity's internally created employee relationships, supplier relationships, customer relationships and goodwill are not recorded on the entity's balance sheet. Likewise, the value of the entity's contingent liabilities are not recorded under U.S. GAAP. Therefore, employee lawsuits, environmental claims, unresolved income tax audits and other claims against the debtor company are typically not recorded on the entity's balance sheet.

Unlike the debtor company's GAAP-based balance sheet, the asset-based approach value-based balance sheet recognizes the current value of (1) all of the company's assets (tangible and intangible) and (2) all of the company's liabilities (recorded and contingent). To conclude the assignment-defined value for the company's assets and liabilities (whether individually or collectively), the analyst will apply generally accepted asset (and liability) valuation methods. These valuation methods are categorized into three categories of generally accepted property valuation approaches: income approach, market approach and cost approach.

When to Apply the Asset-Based Approach

First, it is noteworthy that, under most professional business valuation standards, the analyst should consider applying all generally accepted valuation approaches. Accordingly, the relevant analyst question is not "When should I perform...