There are three approaches to valuing a business. I’ll discuss them in detail.

1. Asset Approach

Asset approach looks at a business from a set of assets and liabilities of the company for business valuation. It’s based on the economic principle of substitution and tries to answer the question:

What would cost me to recreate a similar business that generates the same economic benefits for its owners?

Every operating business holds assets and liabilities. So, valuing these assets and liabilities and taking the difference between the two values would give us the value of the company. While it sounds simple, valuing a business can be a daunting task since most of the components do not find a place in the balance sheet. Internally developed products (unless patented) are such an example. But the market value of these assets can be far greater than the combined value of all the assets that resides in the financial statement.

Few points noteworthy

• An asset-based valuation approach is usually adopted when a business has a very low or negative value as an ongoing business. Consider the case of an airline company that has few routes, high labor and operating costs, and is losing money every year. Using the other valuation methodologies, one can derive a negative valuation for the company. But to its competitors, the assets (routes, landing rights, leases, equipment and airplanes) can have a significant value. In this case, this approach will value the company’s assets separately and will set them aside from the money losing business. The asset-based valuation approach will typically yield the lowest valuation of the 3 approaches for a profitable company, but it may result in an appropriate value depending on the situation.
• Asset approach may be used in conjunction with the other valuation methods. For example, let’s consider a retail business which has only one location. It owns the property and the building in which the business operates. If the company has EBIT of $200,000 and a buyer is willing to pay 3x EBIT for a similar retail business which leases its operating facilities, the buyer will value it by adjusting EBIT for the cost the buyer would have to incur, if it were to lease comparable facilities, and adjusting the company’s valuation for the value of the property and building assets. If the buyer has to pay $20,000 a year for leasing similar property, and can sell the property and building for $600,000, the buyer might value this company at 3x adjusted EBIT, plus the value of the property and building.

3x ($200,000 – $20,000) = $540,000 + $600,000 = $1,140,000

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