First, the valuation expert typically starts with the subject company’s GAAP-based balance sheet. The valuation expert will use the balance sheet dated closest to the analysis valuation date. Preferably, the valuation expert will use the company’s balance sheet that was prepared just before the analysis valuation date. IFRS 13 Adjusted net asset method
Second, the valuation expert identifies and separates (for further analysis) any non-operating or excess assets reported on the balance sheet. Such assets may include vacant land or other assets held for investment purposes. Such assets may also include those assets that are not necessary for the business but that are enjoyed primarily by the business owners.
This asset category may include a private aircraft or a vacation home owned by the company. And, non-operating assets sometimes include the tangible assets of company discontinued operations that are being held for disposal. IFRS 13 Adjusted net asset method
In any event, these excess or non-operating assets are analyzed separately from the adjusted net asset value valuation of the going-concern business.
Third, the valuation expert lists all of the reported account balances for the following categories of business operating assets:
- Working capital assets (including current assets less current liabilities) IFRS 13 Adjusted net asset method
- Tangible assets (including land, buildings, and equipment) IFRS 13 Adjusted net asset method
- Intangible assets (including any recorded identifiable intangible assets) IFRS 13 Adjusted net asset method
- Other assets (such as deferred income taxes and unconsolidated investments) IFRS 13 Adjusted net asset method
The sum of these recorded asset balances represents the amount of the company’s total net operating assets. The total operating assets are typically analyzed net of the current liabilities accounts. However, for this purpose, the current liability component of any long-term debt is excluded from this total.
In other words, the total net operating assets should equal the total long-term debt (including the current portion of that debt) plus the total owners’ equity recorded on the company balance sheet.
Fourth, the valuation expert begins the process of performing an aggregate revaluation of all of the company’s total net assets. The most common valuation method that is used to perform this single, collective revaluation of the net operating assets is the capitalized excess earnings method. The result of the capitalized excess earnings method analysis is often called intangible value in the nature of goodwill.
This capitalized excess earnings method goodwill value represents the total value increment (or value decrement) compared to the company’s recorded cost-based net operating assets.
That is, this capitalized excess earnings method goodwill calculation may not represent the same goodwill calculation that could be indicated by (1) the asset accumulation method of business valuation or (2) the GAAP-based acquisition accounting method residual goodwill calculation.
For both the asset accumulation method and the acquisition price allocation analysis, goodwill represents an individual intangible asset. That goodwill intangible asset is quantified after:
- all of the company tangible assets have been revalued and
- all of the company identifiable intangible assets have been revalued.
In the capitalized excess earnings method analysis, the goodwill calculation typically includes all of the following:
- The total revaluation (above the cost-based accounting balance) of the company’s recorded tangible assets
- The total revaluation (above the cost-based accounting balance) of all of the company’s recorded intangible assets
- The total valuation of all of the company’s identifiable but unrecorded intangible assets
- The valuation of any remaining company business value in excess of the value increment associated with the company’s recorded tangible assets recorded intangible assets, and unrecorded intangible assets
Therefore, in the capitalized excess earnings method analysis, the value conclusion represents more than the value of the company’s residual goodwill amount. The capitalized excess earnings method value conclusion represents an aggregate revaluation of all of the company’s recorded balance sheet accounts.
For this reason, the capitalized excess earnings method conclusion is often referred to as intangible value in the nature of goodwill. That name is intended to distinguish the capitalized excess earnings method goodwill adjustment from the residual amount of goodwill that is concluded (1) in an asset accumulation method analysis or (2) in a GAAP accounting purchase price allocation.
The capitalized excess earnings method analysis involves multiplying a fair rate of return by the company’s net operating assets balance. The mathematical product of this multiplication is called the company’s required earnings. The valuation expert compares the company’s required earnings to the company’s actual earnings.
If the actual earnings exceed the required earnings, then the company is generating excess earnings. The excess earnings are typically capitalized as an annuity in perpetuity. The capitalized excess earnings represents the intangible value in the nature of goodwill for the subject company. IFRS 13 Adjusted net asset method
Fifth, the valuation expert adds the net operating assets balance to the goodwill balance calculated from the capitalized excess earnings method analysis. This summation represents the current value indication for all of the company’s net assets (i.e., total assets minus current liabilities).
The valuation expert can also subtract the company’s long-term debt from the calculated net asset value indication. The remainder of that subtraction process indicates the current value of the company owners’ equity.
Sixth, as a final procedure, the valuation expert will add the value of any excess or nonoperating assets to the value of the net operating assets—in order to conclude a total business value.
Strengths of the adjusted net asset method
The first advantage of the adjusted net asset method is that it is relatively quick and easy to perform. For the most part, the valuation expert only needs the company’s historical financial statements in order to perform the adjusted net asset method analysis.
In other words, the adjusted net asset method is based on the same company financial data that the valuation expert would colllect in order to perform either a market approach or an income approach business valuation.
In contrast, the accumulated asset method analysis requires valuations of each category of the company’s tangible assets and intangible assets. In contrast to the accumulated asset method, the adjusted net asset method does not require the time or the cost of either: IFRS 13 Adjusted net asset method
- the valuation expert performing numerous tangible asset and intangible asset valuations or
- a third-party appraisal specialist performing numerous tangible asset and intangible asset valuations.
The second advantage of the adjusted net asset method is that it is relatively easy for the valuation expert to explain and relatively easy for counsel and other parties relying on the business valuation to understand. The application of the asset accumulation method often involves the use of numerous valuation approaches and methods. And, the asset accumulation method involves valuations of interrelated assets.
Considerations related to contributory asset charges and profit split analyses are often difficult for counsel and other parties relying on the valuation to understand and follow.
A third advantage of the adjusted net asset method is that it is intuitively obvious. The analysis starts with the company balance sheet. If the company earns an amount of income greater than a fair return on its balance sheet assets, then the business value is proportionately greater than its net book value. If the company earns an amount of income less than a fair return on its balance sheet assets, then the business value is proportionately less than its net book value.
Fourth, because of the relatively limited data requirements, the valuation expert does not have to disrupt the company business operations to the same extent as the asset accumulation method. That is, the breadth of management interviews and company visits is often less obtrusive with the adjusted net asset method (as compared to the asset accumulation method). Therefore, it is easier for the valuation expert to perform the adjusted net asset method (than the asset accumulation method) in a litigation valuation environment.
Fifth, the adjusted net asset method can be used effectively and efficiently to identify whether or not the company is earning a fair return on investment for the company owners. This business valuation method also quickly identifies whether the GAAP balance sheet overvalues or undervalues the company’s net assets (in the aggregate).
In summary, the adjusted net asset method allows the valuation expert to perform an asset-based approach analysis without the cost and time requirements of the asset accumulation method.
Such an analysis is usually sufficient to allow the valuation expert to reconcile the adjusted net asset method value indication with the market approach and the income approach value indications in order to synthesize an overall business value summary.
Weaknesses of the adjusted net asset method
First, the adjusted net asset method can be used to conclude the following:
- Subject company total asset value IFRS 13 Adjusted net asset method
- Subject company total business enterprise (long-term debt plus equity) value IFRS 13 Adjusted net asset method
- Subject company total equity value IFRS 13 Adjusted net asset method
The adjusted net asset method cannot be used to estimate the value of any particular asset or bundle of assets. It does not effectively distinguish between tangible asset value and intangible asset value. And, it cannot identify the value of assets that are pledged as debt collateral—compared to the value of assets that are available to pledge as debt collateral.
Second, the adjusted net asset method may be deceptively simple. Valuation experts, legal counsel, judicial finders of fact, and any other party relying on the valuation need to appreciate the importance of each valuation variable in the methodology.
There are different versions of the adjusted net asset method. Some versions involve no revaluation of the company assets. Other versions allow for limited revaluation of certain company assets (such as real estate).
Issues such as the selection of the fair rate of return on assets, the consistency of the level of company income and the rate of return measurement, and the selection of the direct capitalization rate are more complex than they may seem on the surface. IFRS 13 Adjusted net asset method
Third, the adjusted net asset method will conclude a business value for the company. However, and unlike the asset accumulation method, the adjusted net asset method does not identify the source of the business value.
That is, the adjusted net asset method does not determine if any company excess earnings is due to efficient plant and equipment use, strong customer relationships, valuable intellectual property assets, or any other reason.
Fourth, the adjusted net asset method typically doesn’t identify asset spin-off opportunities, undervalued asset refinancing opportunities, or intellectual property license opportunities. In other words, this method indicates a reasonable business value summary. However, this method is limited with regard to telling the company management how to maximize (or even increase) the value of the company.
Fifth, the adjusted net asset method has application limitations with regard to comparing business values under alternative standard of value scenarios and alternative premise of value scenarios.
As a relatively simple methodology, the adjusted net asset method typically concludes a market-based standard of value and a going-concern premise of value. It is difficult to adjust the valuation variables to conclude alternative standards of value or alternative premises of value. IFRS 13 Adjusted net asset method
In summary, as with any valuation method, the valuation expert has to be aware of the importance of each individual valuation variable in the adjusted net asset method. And, the valuation expert has to appreciate that the adjusted net asset method produces a reasonable indication of the company current business value. IFRS 13 Adjusted net asset method
However, this method has a somewhat limited application when it comes to analyzing issues related to alternative tax structures, financing structures, transaction structures, and so forth.