A direct and simple valuation method is based on assets value. The equity value, according to the asset based valuation method, is the total value of the company assets minus the total value of its liabilities. The most common approach is to start with the book value, which can be found in the annual reports. Let is take a look as our case in the article about the WACC method, the privately held limited liable company BriWiFra. And here we present a more detailed balance sheet, derived from the annual accounts, ending year 0:
|Balance sheet in €/1000||year 0|
|Cash and equivalents||20|
|Work in progress||400|
|Total liabilities and equity||2640|
At the valuation moment, end year 0, the book value of the equity is 1160. This can be denoted as the asset based value of the shareholders equity: the total value of the assets, i.c. 2640 minus the total value of liabilities, i.c. 1480. This valuation method seems to be quick and easy. But to this, we must make several remarks. Making the asset based value approach a bit more complex.
The asset based value is derived from the accounting reports. In these reports, assets are valued at historic costs, purchasing costs minus depreciations, face value, fair value (or market value), et cetera. So, we must examine the accounting rules behind the accounting reports, when using them as a foundation for the asset based value of a company.
Furthermore, the sum of individual assets does not reflect the market value or the economic value of the composition. Let us demonstrate this with the help of a human being. The total of his (or her) components adds up to approximately €10. Approximately sixty-five percent is water. Besides some lipides, proteins and minerals. But of course, the value of a human being is much more. Let alone the emotional value.
But apart from that, a human being is a cash generator. This as a crafts(wo)man, a scientist, a trade agent, a movie star, et cetera. Economically seen, the value of a human being is much higher than the estimated €10. Due to his (or her) capacity to earn money.
For an enterprise, the additional value above the asset based value is denoted as goodwill: it reflects the capacity to generate wealth or future cash flows. Whether we like it or not, the assed based value never takes any goodwill into account. This is therefore also the greatest weakness. This limits its applicability. And some valuation experts regard this enterprise valuation method as fully meaningless. And I agree, however to a certain extend!
Let us look into the asset based valuation method a bit further. The asset based value was founded on the balance sheet in the annual financial report. So, therefore a result of a bookkeeping process. If the company, for any reason, decides to revaluate its assets or neglects to add provisions to the current liabilities for a probable occurrence of obligations, then the valuation outcome is certainly higher. So, one can conclude that the asset based value can easily be manipulated.
To avoid such a value manipulation, we need to have a closer look at the asset base. And in the case of BriWiFra, we discovered the following:
- The accounts payable includes a debtor, who is in a financial distress. So BriWiFra can expect that this debtor will never pay his outstanding obligation, i.c. an amount of 100;
- Some of the inventory appears to be obsolete. The value of this obsolete material is 80;
- On the other hand, the fixed assets of BriWiFra have a higher market value than the book value according the annual reports. The economical and technical life of the woodworking machines is longer than the depreciation period. The market value is 1500, thus 300 higher than the book value.
So, it seems to be obvious that one should add 300 and subtract 100 and 80. Giving us an asset based value of 1160 PLUS 120 is 1280. However, this is not a correct valuation outcome. Because this approach is neglecting the effects from VAT and profit tax. This might need some clarification.
Profit tax and VAT
The claim on the debtor, i.c. 100, is including the VAT. Let is assume a 20% VAT rate. BriWiFra might then successfully claim a VAT refund of 17. The remainder. i.c. 83 is a profit tax deductible loss. So, this will cause a tax shield of 25%, which is 21 (assuming that profit is taxed at a rate of 25%). So the total net loss on the debtor is 100 minus a total tax refund of 37.5 is 62.5.
The depreciation on inventory is tax deductible. Here the net loss on the inventory is 80 minus 25% is 60.
The revaluation of the fixed assets is a bit more complex. If we would make a buyer to pay 300 more for fixed assets, leaving the book value to be 1200, then he would not get the future tax claims due to the depreciation over that 300. We therefore must adjust the 300 with the net present value over a depreciation period of 5 year. At a tax rate of 25%, the total of tax returns would be 75. If discounted at a rate of 6%, this would be 54. So, the net revaluation profit would then be 300 minus 54 is 246.
Due to VAT and profit tax, the asset based value is therefore 246 minus 63 minus 60 is 123 more. But there is more work to do!
Market value of debt
At the end of this article a look at the value of debt. Like the market value of the assets, an appraisal of the value of debt is required. The actual interest rate is 6%. But, looking at the solvency, profitability and liquidity of BrWiFra, the risk of default is very limited. A market rate of 4% would be more fair. So, BriWiFra has debt obligations at a too high rate. This has a raising effect on the market value of its debt. If we make an overview of future payments, i.c. interest en redemptions we end up with the following. Note that years 3 through 6 are not shown:
|Market value of debt||yr 1||yr 2||yr 7||yr 8||yr 9|
|Tax returns -25%||-15||-14||-5||-3||-1|
|Total debt service||166||161||134||128||123|
|d = (1-f) * Rd||0,97||0,94||0,81||0,79||0,77|
The future cash outs are discounted at a rate of (1-f) * Rd. In which f is the profit tax rate and Rd is the market rate of interest on debt, i.c. 4%. Then, the total market value of BriWiFras’ debt is 1132. The face value of debt was 1080. So, we should therefore subtract another 52 from the book value to arrive at the assed based value.
Asset base value
The total is overview after the before mentioned adjustments is
|Balance sheet after adjustments in €/1000||year 0|
|Cash and equivalents||20|
|Work in progress||400|
|Total liabilities and equity||2764|
So, is this valuation outcome meaningful? To a certain extend it does. Probably not in he case of BriWiFra. Roughly spoken, BriWiFra generates a yearly free cash flow of 400. This, when ignoring additional investments in fixed assets and net working capital due to growth. If we assume a WACC of 16%, the enterprise value would be 2500, which yields a equity value of 2500 minus 1132 (debt) plus 20 (cash) is 1382. So, one could conclude that the asset based value has little significance.
But, let us assume now that BriWiFra performs 20% worse. Thus generating a poor yearly free cash flow of 320. Then the enterprise value would be 2000, which yields a equity value of 2000 minus 1132 (debt) plus 20 (cash) is 882. The shareholders invested 1232 and end up with an asset which has a lower value.
Then discontinuing the business seems to be a better strategy. Then the liquidation of BrWiFras’ assets will yield a better outcome. However, to be sure, we have to explore the possibility of such a termination and the related costs first.