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    Chapter 5

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    of 12
    CHAPTER The Asset-Based Approach to Valuation 5.1 What Is the Asset-Based Approach? The asset-based approach (also referred to as the cost approach from a business valuation perspective) establishes the value of a business by quantifying the net amount of money required to replace the future service capability of the business assets, It is predicated on the concept that a buyer will pay no more for the assets of the business than the cost to obtain the assers of the business of equal utility, whether by purchase or by construction. The method under the asset-based approach that we will consider in this book is the asset accumulation method which is commonly used in practice. This asset accumulation method is also known by various names. It has ofren been referred ta as one of the following: Adjusted net asset approach; Net asset value approacl Net asset backing approach; Adjusted book value metho Asset build-up method. eee It values the individual assets and liabilities of a company and aggregates them to arrive at a value. [t views the company as a set of assets and liabilities that are used as building blocks to construct the picture of the entity's value. Itis based on the economic principle of substitution which relates to the cost of creating another company that will produce the same economic henefits for the shareholders, As a company has assets and liabilities, a straightforward approach will he to determine 109 110 CHAPTERS * The Asset-Based Approach to Valuation the value of a company as the excess of asscts over liabilities in adjusted valuc terms. In this regard, the value determined is its nec asset value after adjusting or restating its assets and liabilities to. an appropriate standard and premise of value. Although there are several variants to this approach, what is commonly seen in practice is that it is often based on the market value attributed to the assets of the company less the market value of the liabilities of the company as at a specific date (valuation date), normally premised on the assumption that the company is operating as a going concern. At the individual assets and liabilities level, var- ious valuation approaches and their respective methodologies can be considered and applied in determining their value. This method tends to be used for asset- intensive businesses whereby the underlying assets of the company are the value drivers. Examples include investment holding and real estate companies. In certain circumstances where the future prospects of the company are extremely doubtful and/or liquidation is contemplated, this approach is also uti- lised, Under these scenarios, the valuation will normally be carried out under the premise of either an orderly liquidation or a forced liquidation, where a ‘fire sale’ of the assets is carried out. Hence, the asset-based approach can be used to deter- mine the value of a company on both a going concern or liquidation premise. Ivis also worth noting that apart from adopting this as a primary approach to valuing the company, the asset-based approach is often used as a crosscheck to the reasonableness of the value(s) determined using other valuation approaches as well. This is particularly relevant especially if it relates to the level of goodwill and the intangible assets implied in an earnings or cash flow-based valuation, car ried out on a going concern premise, under the market and income approaches. As stated earlier, under this approach, the valuation of a subject company equals its net asset value after adjusting or restating its assets and liabilities to an appropriate standard and premise of value. In order to arrive at the value of the subject company, the market value of its assets is netted off against the market value of its existing and potential liabilities as of the valuation date. At the indi- vidual assets and liabilities level, various valuation approaches and methadolo- gies can be considered and applied in determining their value. It is common and acceptable to use a particular valuation approach, say the market approach, to value a class of asset (¢.g., property), whereas a different valuation approach, say the income approach, is used to value another asset class (c-g., an unquoted invest- ment}. The determination of the relevant approaches ar methodologies to adopt is dependent on their specific nature and features as well as the environment in which assets are employed and liabilities incurred, Some assets and liabilities, which are commonly scen on a company’s balance sheet, are shown in Table 5.1. As compared to the income and market approaches, this approach normally results in the lowest value for a profitable company. This being the case, to the owner of the subject company, it simply implies a minimum value that he should be expecting if he is to dispose of his sharcholding in the company or sell the busi- ness in its entirety. As highlighted above, there are two situations where the asset aceumula- tion method can be carried out, namely, on either a going concern or liquidation premise. The subject assets and liabilities are the same under these two scenarios, bur the value attributed to them may he different. Of these, valuation carried out on a going concern premise will generally produce a higher value. 5.1 What Is the Asset-Based Approach? «991 TABLE 5.1 Common Assets and Liabilities on a Company's Balance Sheet Accounts payable Cash and bank balances Prepayments.and prepaid expenses Accruals: Accounts receivable Provisions Inventories (raw materials, work in progress, fi Finance leases Property, plant and equipment Loans and bank borrowings Quoted and unquoted investments Intangibles Going Concern Premise An example of this situation is when a business is a going cancern but it does not generate adequate or sufficient returns on I. In this situation, the valuation of the subject company is.carried out on the basis that the company will continue to operate at least in the short to medium term and that its assets will not be liquidated. Market value of the assets of the subject company as a going concern business Less Market value of the liabilities of the subject company as a going con- cern business Equals Market value of the subj company In practice, it is generally assumed that the book values! or carrying values of cur- rent assets and current liabilities, other than capital assets such as property, plant and equipment and investments, approximate their market values due to their short-term nature When the market value of a capital growth asset like property exceeds its car- tying value, the resultant incremental value may need to be adjusted for income tax. Such adjustment is subject £0 various factors including jurisdiction, that is, where the asset is located and where the company holding asset is based. For example, in Singapore jurisdiction, under Section 10(1) of the Singapore Income Tax Act (Chapter 134), income tax shall be imposed on gains or profits of an income nature and therefore capital gain in nature shall not be subject to tax. But Singapore tax laws do not specify how to determine whether a receipt or gain is capital in nature bur instead it shall be assessed on a case by case basis given the facts and circumstances of each case, In addition, it is noted that the Singapore tax authorities also make references to precedent law cases in assessing the nature of receipts or gains. A valuer might need to cansult a tax expert on the implica- tion of income tax subject asscts and to make appropriate tax adjustments in determining the business value using the asset-based approach. 1, Book value or carrying value ts the value of the avsetiability that is recorded/stared in the accountsfinancial starements under a set of accounting standards. Please refer ta Chapter 2 for a detailed discussion on book value and carrying valuc. 412 CHAPTERS + The Asset-Based Approach to Valuation TABLE 5.2 Assets and Liabilities of Co A as at the Valuation Date Accounts receivable Inventories 7 Property, plant and equipment 40 Accounts payable (12) Accruals (3) Bank borrowings (15) Net assets Under certain circumstances, it may also be appropriate and necessary to remove the book value of goodwill or any identified intangible assets as the sub- ject company does not generate sufficient earnings or cash flows to justify any premium aver the value of its net tangible asset. No allowance for realisation costs should be considered as the valuation is car- ried out on the premise of a going concern and no liquidation of assets will occur. Example 5.1 Valuation under the going concern premise ‘We are determining the market value of 100% equity interest of A Pte Ltd (‘Co A) with the balance sheet as of the valuation date, as shown in Table 5.2. The book value of Co A’s frechold property amounts to $30 million as of the valu- ation date. For the purpose of this valuation, the company has engaged a real estate valuation specialist to determine the market value of the property. The real estate valuer then assesses the market value of the company’s property to be $41 million, The sale of the company’s property will be subject ro income tax of 17% as of the valuation date. As for the rem sand liabilities, ir has been ascertained ing ass that their carrying value approximates their market value. The company does not have any other surplus assets or off-balance sheet items, By adopting the going concern premise, the market value of Co A can be estimated as shown in Table 5.3. In cases where the income or market approach is adopted as the primary valu- ation approach in valuing the subject company, the value derived from the assct TABLE 5.3 Market Value of 100% Equity Interest of Co A Under the Going Concern Premise -_ (SIMiLLION) Net assets incremental market value of property " Income taxon sale of property (17% of $11 million) 2 Value of 100% equity interest 5.1 What Is the Asset-Based Approach? 113 accumulation method on a going concern premise can be used as a crosscheck of the reasonableness of the valuation results determined using the primary approach Liquidation Premise This situation is appropriate when a business is not viable and its future business is uncertain, The company may be insolvent, loss-making, on the verge of bankruptcy and facing liquidation, Under these circumstances, the valuation of the subject company is carried out on the basis that the company will liquidate its business. The liquidation can be done by either undertaking an orderly realisation of its as- sets to maximise the value (orderly liquidation) or by undertaking a fire sale of its assets to obtain the disposal value in the shortest possible timeframe (farced liqui dation). The liquidation value under the forced liquidation scenario will most likely be significantly lower than that under the orderly liquidation scenario because of the objective to obtain the disposal value at any price in a much shorter timeframe. Market value of the assets of the subject company under liquidation Less Market value of the liabilities of the subject company under liquidation Less Estimated relevant costs in liquidating the subject company Fqual Market value of the subject company In determining the estimated net realisable value of the subject assets and liabili- ties, a valuer should consider the following: Nature and marketability of the subject assets and liabiilit Accounting standards under which the subject assets and liabilities are ac- counted for and reported in the financial statements; * Specialised valuers for the valuation of certain asscts and liabil real estate, long-term employee benefits plan, complex financial instruments, and so on; and * Taxes arising from liquidation of the subject assets and the liquidation process. ies such as In addition, allowance for costs in relation to the liquidation process such as commissions and legal, accounting and professional fees should be included in the valuation. Another point to note is that as the realisation process might take a few months, it is reasonable for a valuer to make an adjustment for a certain level of profit margin attributable to a buyer who is willing to pay for acquiring the business as at the valuation date. Such an adjustment accounts for the time value of money between the valuation date and the expected date of completing the realisation and also the risks associated with the hypothetical transaction under the liquidation scenario. However, in practice such an adjustment is rare as the time gap for liquidation may be short and also, the relevant risks appear minimal. Example 5.2 Valuation under the liquidation premise We are determining the market value of 100% equity interest of A Pte Ltd (‘Co A’) with the balance sheet as of the valuation date, as shown in Table 5.4. Co A has incurred losses for the past few years and liquidation is imminent. If liquidation is undertaken, the liquidation cost would approximate $5 million 114° CHAPTERS * The Asset-Based Approach to Valuation TABLE 5.4 Assets and Liabilities of Co A as at the Valuation Date (SMuui08N) Accounts receivable 10 Inventories 7 Plant and equipment 10 Property 30 Accounts payable (12) Accruals Q) Bank borrowings (5) Net assets In addition, only 90% of the accounts receivable is collectible, and the sale of inventories and plant and equipment would likely recover only 86% and 70% of their carrying values, respectively. An independent valuation report shows the market value of the company’s freehold property to be $41 million as of the valu- ation date. Co A does not have any other surplus assets or off-balance sheet items. By adopting the liquidation premise, the value of Co A can be estimated as shown in Table 5.5, TABLE 5.5 Market Value of 100% Equity Interest of Co A under the Liquidation Premise (SMiti08N) Note Book Vatue = Vatue Apyustment = Marxer VaLue Accounts receivable Inventories Plant and equipment Property Accounts payable Accruals Bank borrowings Adjusted net asset value Liquidation cost Value of 100% equity interest Total may not add up due to round-ofts. Note 1: Market value of accounts receivable = 90% of $10 million Note 2: Market value of inventory ~ 86% of $7 million Note 3: Market value of plant and equipment = 70% of $10 million Note 4: Market value of property = $41 million less 17% of $11 million 5.3 How Do We Apply the Asset-Based Approach? 795 5.2 Why Use the Asset-Based Approach? The asset-based approach is easy to understand as the valuation is carried for each item, line by line, on the balance sheet and hence the valuation res usually presented in a way that is similar to the presentation of the balance she From the valuation results under the asset-based approach, it is easy to identity how much each item is valued to the business. The asset-based approach is best used in the following situations: * Business is not performing well. It does not generate sufficient eash flows or earnings to justify a premium over the value of its underlying net tangible asset; © Business incurs loss and its business prospect is extremely doubrful. The conti- nuity of irs business operations may be in question; * Business is insolvent and faces liquidation; + Investment holding company that holds capital growth assets such as proper- ties or investments; that has intensive assets including significant surplus assets; or Financial reporting purposes where the purchase price is allocated among the assets acquired in a business combination, 5.3 How Do We Apply the Asset-Based Approach? ‘The asset-based approach can be applied and carried out as shown in Figure 5.1. Step 1: Understanding the Business/Industry That the Subject of Valuation Operates in and Identifying Its Assets and Liabilities The valuer has to obtain a good understanding of the business of the subject com- pany and the industry in which it operates. However, the extent of the business ‘Step 1; Understanding the Business/Industry That the Subject of Valuation Operates in and Identifying Its Assets and Liabilities | step 2: Selecting the Appropriate Valuation Standard/Premise and Valuation Specialists (If Required} A 2 ‘Step 3: Performing Valuation of Identified Assets and Liabilities. ‘Stop 4: Making Additional Adjustments and Estimating the Liquidation ‘Cost (Where Applicable) ‘Step 5: Deriving the Valuation Range of the Subject Company FIGURE 5.1 Valuation Steps under the Asset-Based Approach 116 CHAPTERS * The Asset-Based Approach to Valuation and industry analysis under the asset-based approach will not be ay detailed as that of the other approaches. The following preliminary areas serve as a good start when analysing the subject company: * Business description and operations; * Locations of business operations; + Historical and forecast financial performance (revenue, profitability, ete.); and © Industry analysis. In identifying, the assets and liabilities of the subject company, the starting point for a valuer would be the balance sheet as of the valuation dare. In addition to the examination of information made available, the valuer will conduct further discussions with the management of the subject company to identify off sheet items which may be of bearing to the valuation outcome. alance Step 2: Selecting the Appropriate Valuation Standard/Premise and Valuation Specialists (If Required) The selection of the valuation standard/premise will depend on the following: ‘Terms of the valuation engagement; Discussion with the relevant parties or manageme to understand the purpose of valuation and the company’s business operation; Availability and quality of information; and Findings fram the analysis of historical and forecasted financial performance of the subject company of the subject company urrent status of the subject The going concern premise is appropriate when a business can still be in opera- tion for at least in the short to medium term and when the liquidation of assets is not foreseeable as at the valuation date. In addition, the going concern prem- ise is also applicable if the asset-based approach is undertaken primarily to be used as a crosscheck on the valuation outcome determined using other valuation approaches, On the contrary, if the subject company’s business is not viable and its opera- tion continuity is extremely doubtful oF if it is facing potential liquidation, then the liquidation premise will be more appropriate for the valuation of the subject company, In addition, when analysing and identifying assets and liabilities (including off-balance shect items) of the subject company as of the valuation date, the valuer may consider engaging other valuation specialists to perform valuation for certain specialised assets and liabilities such as real estate, plant and equipment and financial instruments. Step 3: Performing the Valuation of Identified Assets and Liabilities The next step is to restate identified assets and liabilities to an appropriate stan. dard of value (e.g., market value, fair value), Table 5.6 provides examples of how certain assets and liabilities are valued and accounted for under the going concern and the liquidation premises. 5.3 How Do We Apply the Asset-Based Approach? 147 SEE SE TEA TABLE 5.6 Examples of Certain Assets and Liabilities Valued under the Going Concern and Liquidation Premises Asser or Liasuiry Description GoInG Concern PREMISE Liquioation Premise Cash and bank balances Quoted investment Unquoted investment Prepayments or prepaid expenses Accounts receivable Raw materials Work in progress. Finished goods Property, plant and equipment: Carrying value Current market value Carrying value or estimated market value depending on the availability and quality of information for valuation Carrying value Carrying value less any addi- tional allowance for bad and doubtful debts Lower of cost and n| realisable value Lower of cost and net realisable value Lower of cost and net realisable value Carrying value or market value determined by a valuation specialist Carrying value Current market value less any selling cost to be incurred Estimated market value less any selling cost to be incurred Estimated net realisable value less any relevant cost to be incurred for the realisation of the subject assets Estimated net realisable value less any relevant cost to be incurred for the collection of the subject assets Estimated net realisable value less any selling cost to be incurred Estimated net realisable value less any relevant costs including cost to complete (if any) and selling cost to be incurred Estimated net realisable value less any selling cost to be incurred Estimated net realisable value less any selling cost such as advertising and agent commissions Intangibles Accounts payable Accruals Loans, bonds, Finance leases and bank borrowings Carrying value or revalued amount Carrying value Carrying value Carrying value or quoted market price or market value to be determined by a valuation specialist Estimated net realisable value less any selling cost to be incurred Carrying value Carrying value Carrying value depending on the nature of the subject liabilities Secured creditors and preferential

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