The Asset Approach Made Simple
The IRS has outlined several valuation approaches experts can use to conduct fair and consistent small business valuations. One of these valuation methods is the asset approach. At Peak Business Valuation, we frequently use the asset approach when valuing a small business.
A common method under the asset approach is The Adjusted Book Value Method. This asset approach involves adjusting the book value of a company’s assets and liabilities to reflect their current market values. For more information on how to value a business, check out Common Business Valuation Approaches.
As a professional business appraiser, Peak Business Valuation helps thousands of businesses throughout the United States. We can provide you with a fast and accurate small business valuation whether you are buying, growing, or selling a business. To get started with your small business valuation, schedule a consultation below!
Valuing a Business with the Asset Approach
In the following sections, we explain how valuing a business with the asset approach works. If you have any questions on valuing a small business, reach out to Peak to schedule a free consultation!
Step 1: Understanding Assets & Liabilities
First, a business appraiser analyzes the company’s balance sheet. The balance sheet lists the book values of the company’s assets and liabilities. However, this value typically does not reflect the actual fair market value of the company’s assets and liabilities. As such, the valuation expert makes adjustments to ensure accuracy.
For example, inventory might be valued at current replacement cost, intangible assets might be adjusted or excluded, and machinery or equipment might need to be appraised. In addition to making fair market value adjustments, any non-operating assets and liabilities must be removed.
Non-operating assets and liabilities refer to items that don’t influence the core operations of the business. For example, the owner of the company has two personal vehicles and associated loans on the balance sheet. Since the business does not require vehicles to operate, these would be considered personal or non-operating assets and would be removed from the adjusted book value exercise. Another example would be real estate or other investments. Real estate holdings not used in the business’s operations are non-operating assets and would be removed from the balance sheet.
Determine the Fair Market Value of Assets
There are multiple ways to determine the fair market value of each asset and liability. Ideally, individual appraisals would be performed to determine the fair market value for each asset. Some common examples include inventory appraisals and machinery and equipment appraisals. However, due to cost or timing constraints, another common approach would be to use a percentage of the item’s original cost as a proxy for fair market value.
For example, if a piece of machinery costs $75,000 and was placed in service 10 years ago, the book value might show $0 because of depreciation. However, this doesn’t reflect the actual fair market value of the asset. If the analyst were to use a percentage in place of the fair market value, such as 30% of the original cost, then the adjusted fair market value would be $22,500. If a machinery and equipment appraisal was performed and the fair market value of the asset was found to be $25,000, then that figure would be utilized in the adjusted book value exercise.
Determine the Fair Market Value of Liabilities
The same methodology applies when it comes to assessing and adjusting liabilities. Non-operating liabilities are identified and removed, and adjustments are made so the liabilities accurately reflect the required amounts to repay debt. If there are penalties or other adjustments such as accelerated payments, these would need to be taken into account.
The goal is to adjust the values for each asset and liability to reflect fair market value. In other words, how much would the assets be worth if you sold them today as is? How much would it cost to settle each of the liabilities?
Step 2: Calculating Owner’s Equity With The Asset Approach
After determining the fair market value of the assets and liabilities, a business appraiser subtracts the adjusted liabilities from the adjusted assets to determine the net asset value of the business.
Whatever is left is the value of the owner’s equity (basically, what the business owner(s) would have if they sold all assets and paid off all debts). This exercise is underpinned by a derivative of the fundamental accounting equation:
Value of Assets – Value of Liabilities = Owner’s Equity
Example Using the Asset Approach
Here’s a simple example of the asset approach in action:
Imagine you own a home (asset) that you bought for $400,000. However, you owe $300,000 on the home (liability).
If we use the asset approach to calculate your equity in the home (owner’s equity), we apply the following equation:
$400,000 (Cost of Home) – $300,000 (Value of Liability) = $100,000 (Owner’s Equity)
But wait! You bought the home for $400,000 a few years ago. Does $400,000 still accurately represent the fair market value of the home? No! So you bring in an appraiser and they determine that the fair market value of your home is currently $485,000.
Now, if we use the asset approach to calculate your equity in the home, the updated equation would be as follows:
$485,000 (Fair Market Value of Home) – $300,000 (Value of Liability) = $185,000 (Owner’s Equity)
Conclusion
When valuing a small business, a business appraiser may use a variety of approved valuation methods. One common method is the asset approach. This method helps experts understand a business’s value based on the value of its assets and liabilities.
At Peak Business Valuation, we often use the asset approach for asset-heavy businesses such as construction companies. In addition to performing business valuations, Peak Business Valuation can also provide you with machinery and equipment appraisals for these types of companies. To learn more about machinery and equipment appraisals, read What is a Machinery and Equipment Appraisal?
Peak Business Valuation is happy to provide you with a small business valuation or equipment appraisal whether you are buying, expanding, or selling a business. We can also discuss any questions on how to value a small business or valuing a small business using the asset approach. Get started today by scheduling your free consultation with Peak Business Valuation below!
