M&A Fundamentals – The Asset Method of Business Valuation
The asset method of putting a value on an M&A target assumes that the enterprise value of the business is based on the market value of the net tangible assets it owns. The textbook definition of an asset valuation is:
“The value of an enterprise is equivalent to the COST of REPLACING its assets with ones of comparable utility.”
If an M&A professional uses an asset method to value an M&A target their perspective is that the value of the business is reflected in the assets and liabilities represented in its balance sheet. This is a very static view of value and takes no account of the value of potential future growth in income and the balance sheet that can be generated by a successful M&A target.
We look at asset valuations in more depth in our Advanced Business Valuation Training Course.
To start the valuation process of an M&A target a list of relevant assets and liabilities will be taken from the company’s latest balance sheet. Table 1 shows a typical layout for an asset valuation of an M&A target.
Table 1: Layout of a valuation by asset method for an M&A target
Note that cash balances and debt (loans) are not include in this list. This is because a typical offer for an M&A target is made “free of cash and debt”. This terminology is explained in another article in this blog.
The asset valuation table shows two columns for the value of M&A target’s assets – book value and realisable value. Book value is the value of the assets as shown in the latest balance sheet. Realisable value is the price the assets would fetch if they were sold on the open market. Although modern accounting standards require companies to regularly review the value of assets represented in their balance sheets, the balance sheet may still not reflect the achievable selling price if the asset is to be sold in a timely manner.
It is worth looking at some of the issues that typically arise in the valuation of an M&A target using the business valuation by asset method approach.
ELEMENTS OF THE ASSET VALUATION CALCULATION
The fixed asset classification covers a wide range of assets that might be used by an M&A target. The defining quality of a fixed asset is that it must have a tangible physical form. Fixed assets range from land and buildings owned by the company, to plant and equipment used in the business, office furniture and computer equipment.
As part of the due diligence phase of an M&A transaction the buyer will almost always seek a professional, third-party evaluation of land and buildings by a qualified real estate specialist. There are also professionals who specialise in the valuation of second-hand plant, furniture and computer equipment.
Most companies depreciate plant and equipment on a straight-line basis. This means they charge the same annual depreciation for the asset to the income statement each year until the book value is reduced to zero. In practice, the realisable value of a piece of equipment might reduce by 50% as soon as it is put into use, and when fully depreciated retain perhaps 30% of its original cost. For this reason book values of fixed assets rarely reflect the realisable value.
This classification includes the revolving assets used within the business. The main elements of current assets are inventory that will eventually be used in operations or sold to customers, and trade receivables that will eventually be paid by customers.
In the due diligence phase of the M&A transaction a buyer will make detailed enquiries about the condition and status of the inventory. Issues that might impact the asset value of inventory for an M&A target include: the valuation of out of specification inventory, the age of individual inventory items, and the value to be placed on slow moving items of inventory.
Trade receivables will receive similar attention in M&A due diligence. Issues that might impact the asset value of receivables for an M&A target include the valuation of receivables that are being challenged by customers, and receivables that a past due date for payment.
The intangible asset found most often in the balance sheet of an M&A target is goodwill arising from previous acquisitions. Goodwill on acquisition is the difference between the net asset value of an acquire business at the date of acquisition, and the price paid for the business. Goodwill on acquisition would typically be excluded from the asset valuation process.
More problematic from an M&A asset valuation perspective are intangible assets that have been created in the balance sheet reflecting the cost of developing a new product or service for sale to customers. Under accounting standards these balances will be amortised against revenues when the product goes on sale to customers. The M&A professional will need to make assessments of the viability of the project (will it eventually be a saleable product) and the amount reserved. Buyers will often try to estimate how much it would cost to develop the product using their own resources.
The main current liability in most valuations of M&A targets will be trade payables. Issues that might impact the liability for trade payables in an M&A target’s balance sheet include, are all the payables for the M&A target recorded in the balance sheet, and do any of the payables have variable elements. Variable elements for a payable might include discounts that are available from vendors only if certain volume targets are achieved.
Contingencies are always a challenging area when preparing asset valuations of an M&A target.
The most common contingencies in the balance sheet of an M&A target are warranty provisions, deferred tax provisions, estimates of litigation and settlement costs, and provisions for environmental liabilities such as clean-up costs. The basis of contingency calculations will be reviewed during due diligence and usually subject to independent expert review.
On occasions the M&A professional will come across M&A targets with defined benefit pension plans. Although many of these plans have been closed to new entrants there may still be an underfunded liability for the pension obligations in the M&A targets balance sheet. If this is the case an actuarial assessment will be necessary to ascertain the full extent of the underfunded liability.
WHEN MIGHT AN M&A PROFESSIONAL USE AN ASSET METHOD OF VALUATION?
Asset methods of valuation are used in M&A transactions for three main purposes.
VALUATION OF INSOLVENT COMPANIES
If a company is insolvent or has very low profits and cash flow it may be impossible to use discounted cash flow and ratio-based multiples methodologies to put a value on an M&A target. In these circumstances the asset value is often referred to as the “break-up” value. The existing owners could cease trading and sell of the assets at this value to liquidate the company. This effectively puts a floor on the price the sellers would accept for an M&A target.
VALUATION OF ASSETS AS SECURITY FOR DEBT
If the acquiring company intends to finance the purchase of the M&A target with debt lenders will require up to date realisable values of the assets that will be used as security. Some types of M&A participants, in particular private equity, and venture capital companies, rely on high levels of debt finance as part of their business model. Accurate asset valuations of M&A targets are essential for these companies.
VALUATION OF ASSETS FOR INCLUSION IN A JOINT VENTURE
If two companies are pooling operations in a joint venture M&A transaction several metrics are used to decide the share of equity in the combined entity that accrues to each participant. The realisable value of the assets contributed to the joint venture by each participant may be one of the measures used.
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