CHAPTER 2 ASSET-BASED VALUATION

ASSET-BASED VALUATION

 Asset has been defined by the industry as transactions that would yield future economic benefits as a
result of past transactions. Hence, the value of investment opportunities is highly dependent on the value
that the asset will generate from now until the future.

 In practice, valuation is a sensitive and confidential activity in their portfolio management. Valuation
should be kept confidential to allow the company to negotiate a better position for them to acquire an
opportunity.

 Green field investments are investments that started from scratch.

 Value shall be based on pure estimates.

 Brown field investments are those already in the going concern state, as most businesses are in the
optimistic perspective that they will grow in the future.

 Opportunities that can be either partially or fully operational.

 Considered as going concern business opportunities (GCBO)

 Going Concern Business Opportunities (GCBOs)

 These are the businesses that has a long term to infinite operational period. The risk indicators of
GCBOs are identified easily and can be quantified accordingly.

 The Committee of Sponsoring Organization of the Treadway Commission (COSO) suggests that risk
management principles must be observed in doing businesses and determining its value.

SOUND ENTERPRISE-WIDE RISK MANAGEMENT ALLOWS THE COMPANY TO:

 Increase the opportunities;
 Facilitates the management and identification of the risk factors that affect the business;
 Identify or create cost-efficient opportunities;
 Manages the performance variability;
 Improve management and distribution of resources across the enterprise;
 Make the business more resilient to abrupt changes.

ASSET-BASED VALUATION

 Since the entire company is driven by its asset base, the value of the company can be best attributed to
the value of assets.

 In asset-based valuation, familiarity with the generally accepted accounting principles is a key attribute
for an analyst to enable them to establish the value.
  Among the popular method used to determine the value using assets as its bases are: (1) book value
method; (2) replacement value method; (3) reproduction value method; and (4) liquidation value
method.

BOOK VALUE METHOD

 Book value can be defined as the value recorded in the accounting records of the company.

 Book value is highly dependent on the value of the assets as declared in the audited financial statements,
particularly the balance sheet or the statement of financial position.

 IAS no.1 requires that the statement of financial position to summarize the total value of its assets,
liabilities and equity of a firm.

 Assets are required to be categorized into current and non- current.

 Liabilities is also categorized as current and non-current.

 Book value method – the value of the enterprise is based on the book value of the assets less non-equity
claims against it.

Formula:

Illustration:
Golden Crown Corp. in the year 2021 presented their statement of financial position with the following
balances: Current Assets – P500 Million; Non-current Assets – P1 billion; Current Liabilities – P200 Million;
Non-current Liabilities - P700 Million and the Outstanding shares is 1 Million.

REPLACEMENT VALUE METHOD

 Replacement cost – the cost of similar assets that have the nearest equivalent value as of the valuation
date.(National Association of Valuators and Analysts)

 Replacement value method the value of the individual assets shall be adjusted to reflect the relative
value or cost equivalent to replace that asset

 Factors that can affect the replacement value of an asset:

 Age of the asset – enable the valuator to determine the costs related in order to upkeep a similarly aged
asset and whether assets with similar engineering design are still available in the market.

 Size of the asset – is important for fixed assets particularly real property where assets of the similar size
will be compared.
 Competitive advantage assets which have distinct characteristics are hard to replace However, the
characteristics and capabilities of the distinct asset might be found in similar, separate assets
 REPRODUCTION VALUE METHOD

 Reproduction value is an estimate of cost of reproducing, creating, developing or manufacturing a

similar asset.

 Reproduction value method requires reproduction cost analysis which is internally done by companies
especially if the assets are internally developed.

 This method is useful in calculating the value of new start- up businesses, ventures that use specialized
equipment or assets, firms that are heavily dependent on intangible assets and those with limited
market information.

STEPS IN DETERMINING THE EQUITY VALUE USING THE REPRODUCTION VALUE METHOD
ARE AS FOLLOWS:
 Conduct reproduction costs analysis on all assets
 Adjust the book values to reproduction costsvalues (similar as replacement value)
 Apply the replacement value formula using the figures calculated in the preceding step
Illustration:
Using the information of Golden Crown Corp., supposed that it was noted that the 80% of the total non-current
assets are cheaper by 10% of the book value when reproduced. 20% of the total non-current assets are
comprised of goodwill which upon testing was proven to be valued correctly.

LIQUIDATION VALUE METHOD

 Liquidation value refers to the value of a company if it were dissolved and its assets are sold
individually. (CFA Institute)

 Liquidation value represents the net amount that can be gathered if the business is shut down and its
assets are sold piecemeal.

 In some texts, liquidation value is also known as net asset value

 Liquidation value method is an equity valuation approach that considers the salvage value as the value
of the asset. This assumes that the reasonable value for the company to be purchased is the amount
which investors will realize in the end of its life or the value of the business when it is terminated.
  Once the business closes, synergies generated by assets working together or by applying managerial skill
to these assets are lost which reduces firm value.

 In addition, liquidation value may continue to erode based on the time frame available for liquidating
assets.

 For example, perishable inventories should be sold immediately or else it cannot be sold anymore.

 Circumstances clearly dictates whether it will be appropriate to use liquidation value or going concern
value in valuation exercise. If a business is profitable or has sustainable growth prospects, these will
normally show future cash flows which will result in firm value that is higher than if the assets are just
separately like in a liquidation.

 However, if liquidation value becomes higher compared against going concern value, this may signal
that a significant business event transpired which makes the liquidation value more appropriate in
valuation exercise.

 Liquidation value is the base price or the floor price for any firm valuation exercise.

 Liquidation value should not be used to value profitable companies as this approach does not consider
growth prospects of the business.

 Liquidation prices can be difficult to obtain as these are not readily available.

 Instead, liquidation value should be used for dying or losing companies where liquidation is imminent to
check whether profits can still be realized upon sale of the assets owned.

SITUATIONS TO CONSIDER LIQUIDATION VALUE

a. Business Failures – low or negative returns are signs of business failures that is why it is the common or usual
reason why a certain business closes or liquidates.
Types of Business Failures

Insolvency, when a company cannot pay liabilities as they become due.

Bankruptcy, when liabilities become greater than an asset balance.

Factors causing Business Failures

 Internal Factors – can come from mismanagement, poor financial evaluation and decisions, failure to
execute strategic plans, inadequate cash flow planning or failure to manage working capital.
 External Factors – are severe economic downturn, occurrence of natural calamities or pandemic,
changing customer preferences, and adverse governmental regulations.

b. Corporate/Project End of Life – normally, corporations have stated their finite life in their Articles of
Incorporation. If there will be no extension on the corporate life, the terminal value may be computed using
liquidation value

c. Depletion of Scarce Resources – this is most applicable to mining and oil where availability of scarce
resources influences the value of the firm. Liquidation happens in this business when the permits or contracts
with the government expire and the operation will no longer be allowed to execute.
 GENERAL PRINCIPLES ON LIQUIDATION VALUE

Liquidation value is the most conservative approach among all as it is considers the realizable value of the asset
if it is sold now based on current conditions. This captures any markdowns (or markups) that potential buyers
negotiate to buy the assets.

If the liquidation value is above income approach valuation (based on going concern principle) and liquidation
comes into consideration, liquidation value should be used.
If the nature of the business implies limited lifetime (e.g. quarry, gravel, fixed term company etc.), the terminal
value must be based on liquidation. All costs necessary to close the operations (e.g. plant closure costs, disposal
costs, rehabilitation costs) should also be factored in and deducted to arrive at the liquidation value.

Non-operating assets should be valued by liquidation method as the market value reduced by costs of sales and
taxes. Since they are not part of the firm’s operating activities, it might be inappropriate to use the same going
concern valuation technique used for business operations. If such result is higher than net present value of cash
flows from operating the asset, the liquidation value should be used.
Liquidation value must be used if the business continuity is dependent on current management that will not stay.

Types of Liquidation
 Orderly liquidation – assets are sold strategically over an orderly period to attract and generate the
most money for the assets
 Liquidation process will expose assets for sale on the open market with a reasonable time allowed to
find a purchaser, both the buyer and seller having knowledge of the uses and purposes to which asset
is adapted and for which it is capable of being used, the seller being compelled to sell and the buyer
being willing, but not compelled, to buy.
 Forced liquidation – assets are sold as quickly as possible, such as at an auction.

 Liquidation is done immediately especially if creditors have sued or bankruptcy is filed.

 Assets are sold in the market at the soonest time possible which result in lower prices because of the
rush sale.

 Ultimately drives down the liquidation value.

CALCULATING LIQUIDATION VALUE

 Liquidation value considers the present value of the sums that can be obtained through the disposal of
the assets of the firm in the most appropriate way, net of the sums set aside for the closure costs,
repayment of the debts and settlement of all liabilities, and net of the tax charges related to the
transaction and the costs of the process of liquidation itself.

 It can also be computed on a per share basis by dividing total liquidation value by outstanding ordinary
shares and be considered together with other quantitative and qualitative metrics to justify business
decisions to be made.
 Calculation for liquidation value at closure date is somewhat like the book value calculation, except the
value assumes a forced or orderly liquidation of assets instead of book value.

 Book value should not be used as liquidation value.

 Liquidation value can be obtained based on the potential sales price of the assets being sold instead of
relying on the costs recorded in the books.

 Liquidation value is far more realistic as compared to the book value method

 Liquidation value should be based on the potential earning capacity of the individual asset when sold to
the buying party instead of the original capital investee

 The present value of a business or property on a liquidation basis is computed as: the estimated net
proceeds should be discounted at a rate reflects the risk involved back to the date of the original
valuation.

 Liquidation value can be used as basis for terminal cash flow in DCF calculation in order to compute
firm value in case there are years that the firm will still be operational prior to liquidation.

 Special consideration should be emphasized for intangible assets like patents and internally developed
software programs which are often unsaleable.

 When takeovers occurs, it is usual that goodwill is recognized as part of the transactions.

 Monetary equivalent specific for intangible assets cannot be reliably and separately measured.

 Instead, intangible assets are offset against shareholders’ equity to come up with conservative liquidation
value
ILLUSTRATION 1
Pearl Company below balances based on its accounting books records. Pearl company has 250,000 outstanding
shares’

Pearl Company December 31, 2020

Pearl Company is undergoing financial problems and management would like to assess liquidation value as part
of their strategy formulation. If assets will be sold/realized, they will only realize amount based on the table on
the next slide.

To compute for the adjusted value of the assets, the current book value should be multiplied by the assumed
realizable value if they are liquidated. Next, the liabilities should be deducted from the asset adjusted value to
arrive at the liquidation value (or net asset Value).
ILLUSTRATION 2
Golden Company, which is a company specifically created for a venture agreement to extract gold, will end its
corporate life in 3 years. Net Cash Flow expected during the years it still operate is at P3,000,000 per year. At
the end of its life. Golden estimates to incur P10,000,000 for closure and rehabilitation costs for its mining site
and other costs related to the liquidation process. Cost of capital is set at 10%. Remaining assets by end of the
corporate life will be bought by another company for P30,000,000 and remaining debt of P4,000,000 will be
fully paid off by then. If the valuation happens now, compute for the value of Golden Company.

Since Golden Company will terminate its life after 3 years, it is more appropriate to use liquidation value as
terminal value input to the DCF model. For the three years prior to the closure, Golden Company will continue
to generate positive Net Cash Flow and this will form part of its value.

Year 3, terminal value will be based on the liquidation value by end of Year 3.
Cash flows during the remaining operating life and liquidation value by end of year 3 should be combined to
arrive at the value of Golden Company now.

Value of Golden Company = PV of Cash Inflows during years in Operation + Liquidation Value

Value of Golden Company = P7,460,556 + P12,021,040

Value of Golden company = P19,481,596

ILLUSTRATION 3
Diamond Company’s statement of financial position revealed total assets of P3 million, total liabilities of P1
million, and 100,000 shares of outstanding ordinary shares. Upon checking with potential buyers, the assets of
Diamond can be sold for P1.8 million if sold today. Additional P300,000 will also be incurred to cover
liquidation expenses. How much is the liquidation value of Diamond Company per share?

To compute for the liquidation value in this example, we need to consider how much the company will receive
from the assets if it will sell today. This money will also be used to pay for the remaining liabilities and
liquidation expenses.

 Liquidation Value = Sale of Assets upon Liquidation – Payment for Liabilities – Liquidation costs

 Liquidation Value = P1,800,000 – P1,000,000 – P300,000

 Liquidation Value = P500,000

 Liquidation Value per Share = Liquidation Value / Number of Outstanding Ordinary shares

 Liquidation Value per share = P500,000 / 100,000

 Liquidation Value per share = P5.00 per share