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The Art and Science of Valuation Part -5

Asset or Cost Approach to Valuation

The Assets Based Approach to Valuation considers the fair value of a company’s assets after deducting the liabilities from it. This fair market value is derived after evaluating the assets. This asset approach to valuation is usually used by the companies going into liquidation or companies in the financial or investment industry.

This approach, however, does not take into consideration future potential earnings and profits. Therefore, the real value might not be ascertained. It is a very complex method and requires profound knowledge, experience, and accuracy.

The Net Asset Value Approach or the NAV is appropriate for companies that have already reached their mature stage and declining growth cycle, holding companies, companies with strong asset bases, recently created assets, investment businesses, early-stage businesses, etc.

There are the main methods of valuation under the assets approach. They are as follows:

The asset/cost approach has 3 main methods of valuation under it.

Replacement Cost Method

The Replacement Cost Method is based on the assumption that the value of a company is equal to the amount required to replace the company which is in existence. It is more about replacing the asset’s utility or the company and not the exact physical properties. This assumes that the current design and the current materials and techniques are being used. This method assumes that the company continues to operate and that the company does not go into liquidation. The replacement cost does not usually include the assets that are not used for the company’s day-to-day operations. The adjustments regarding the physical deterioration and all relevant forms of obsolescence should be taken into consideration.

Steps involved in this method:

The replacement cost method has 3 steps

  1. The first step involves calculating and finding all the relevant costs incurred if the same asset or the company in the same industry were to be created or obtained, which may not have the same physical properties but with the same utility.

  2. The second step would be to determine and adjust for depreciation and obsolescence associated with the company or the asset.

  3. The third step would be to arrive at the asset’s value or the company's by deducting the total depreciation from the total costs.

Reproduction Cost Method

The reproduction cost method has 3 steps.

The reproduction Cost Method measures the cost of reproducing an asset or a company or a property with the exact physical properties, specifications, and utilities. This is different from the replacement cost method because it estimates the cost of reproducing rather than replacing it.

The reproduction cost method of the assets approach to valuation is suitable for circumstances where the cost of a modern equivalent asset is greater than the cost of recreating the subject asset and when the utility offered by the asset undervaluation can only be provided by the replica rather than a modern equivalent. Steps in valuation using the reproduction cost method:

  1. The first step involves calculating the costs incurred if the asset’s identical replica undervaluation is to be created.

  2. The second step consists of the determination and estimation of depreciation and external obsolescence.

  3. The third step involves adjusting and deducting the depreciation from the cost to arrive at the asset’s value.

Summation Method

The summation method of the asset-based approach to valuation is also called the sum of the parts method or the Underlying Assets Method. This is the most appropriate method for valuing investment companies and other assets or companies whose value majorly depends upon their holdings. The steps involved in valuation using the summation method are as follows:

  1. The first step involves valuing each asset or entity’s asset and liability undervaluation using appropriate methods and techniques.

  2. Adding all the values of individual assets and liabilities helps ascertain the value of the entity or asset under study.

Weighted Average of the Valuations

The valuation of an asset should be done only in one method if a higher degree of confidence has been vested in the reliability of the same. If there is insufficient confidence in the reliability of a single method, then multiple methods and approaches can be used.

In such a case, the weighted average of the multiple approaches or methods may arrive at the value. However, in case of significant variations in the values obtained in different ways, a weighted or simple average might not be appropriate. The valuations must be revised accordingly. The most reliable one should be chosen.

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