A Beginner's Guide to Firm Valuation. Part 1: Asset-Based Valuation
This article is the first part of the Business Compendium's Beginner Guide to Firm Valuation.
Asset-based valuation is one of the four methods used to determine whether a firm is undervalued or overvalued relative to its stock price (Birkinshaw & Mark, 2015). There is no single universal method of valuing a company. Instead, it is a set of models used to analyse the firm's financial statements to estimate what the firm is ultimately worth (Birkinshaw & Mark, 2015). The ability to effectively calculate a company's value is an essential skill in finance and investment. Value investing strategies are applied by professionals and individual investors to identify companies in distressed conditions whose stock's price does not reflect their intrinsic value (The Chartered Institute for Securities & Investment, 2020: henceforth, CISI). Many investment managers call those undervalued shares' bargain stocks'. In fact, Warren Buffett, whose investing strategy was hugely influenced by Benjamin Graham (the author of 'The Intelligent Investor'), built his wealth around the notion of value investing.
Business Compendium prepared the guide to explain techniques utilised by finance analysts and professionals to value a company, which J. Birkinshaw and K. Mark explain in their books ‘Key MBA Models’. Authors identified four main methods:
asset-based valuation;
comparable transaction valuation;
discounted cash flow; and
dividend discount model.
In this article, we discuss the first method called ‘asset-based valuation.’ By the end of the fourth article (dividend discount model), you will not only understand those basic yet essential concepts in finance; but it can also help you to decide when to buy or sell shares.
Asset-based valuation
The asset-based approach to valuation is relatively easy to apply and less complex than other models. It indicates that the business is estimated as being worth the value of its net assets (source: ACCA Global, 2012). Professor of Finance at the Stern School of Business of the New York University, Aswath Damodaran, distinguishes between three valuation approaches. In intrinsic valuation, a value of the business is based upon the cash flows; in relative valuation, the business's value is based upon how similar businesses are priced. In asset-based valuation, the value of individual assets determines the value of the business. Those assets can be both tangible and intangible.
''The asset-based valuation approach focuses on a company's net asset value (NAV), or the fair market value of its total assets minus its total liabilities, to determine what it would cost to recreate the business''.
source: Deloitte, 2017
On the balance sheet, net asset value of the company should always equal the firms’ equity. Example of this calculation is shown in figure 1.
NAV = total assets – total liabilities
Total assets = equity + total liabilities
Figure 1. Simplified balance sheet of Balfour Beatty plc for year-ended 2018 & 2019
The net asset value of the construction company, Balfour Beatty plc, was £1.37bn at the end of the financial year in 2019 (31 December 2019) - an increase of £136 million from the previous year. As of April 2021, Balfour Beatty's market capitalisation (outstanding number of shares multiplied by the price of one share) was £2.08bn (source: Yahoo Finance). Using the pro-rata calculations and Balfour Beatty plc share's price of 265.8p on 1 January 2020, we could assume that the company's market cap back in December 2019 was approximately £1.7bn, given the company has not increased or decreased its outstanding shares. This shows that the difference between the net asset value and market capitalisation is not that significant as it can be the case for other companies.
Arnold & Lewis (2019), in the book Corporate Financial Management, provided an example of AstraZeneca, whose market capitalisation ($80bn) in 2016 was over four times bigger than its NAV ($16.7bn), while some companies had greater NAV than market capitalisation; for example, Vodafone or Bloomsbury. Other examples are listed in figure 2. The authors also discussed the case of Unilever's NAV, which was significantly smaller than its market cap (£17bn vs. £45bn). Arnold & Lewis explained that "this great difference makes it clear that Unilever shareholders are not rating the firm based on balance sheet net asset figures."
Figure 2. Net asset values and market capitalisation of some firms. Available at https://ereader.perlego.com/1/book/871263/771
The asset-based approach alone is rarely used to determine whether the company's share price is overvalued or undervalued. It does not take into account income flow, which is a crucial consideration for any investor and business analyst. To determine the company's intrinsic value, Warren Buffett refers to its income projections. He believes that the value is hidden in a company's income flows. At one of Berkshire's Annual Management Meeting, Buffett explained the importance of cash flows by comparing them to coupons which investors receive when purchasing a bond. His analogy of the bond's coupon and firm's income flow is described with the following passage:
‘‘… [that would give us a number for intrinsic value]. In other words, it would be like looking at the bond that have a ‘whole bunch of coupons’ that were due in hundred years. If you could see what the coupons are you could figure the value of that bond… or you could compare one Government bond with 5% coupon to another Government bond with 7% coupon. Each one of those bonds has a different value, because they have different coupons printed on them… Businesses have coupons that [will also] develop in the future. The only problem [‘coupons ‘] are not printed on the instrument, and it is up to the investor to try to estimate what those coupons [will be] over time.’’
ACCA Technical Paper (2012) titled ‘Business Valuation’ suggests three common ways of valuing net assets on the balance sheet: book values, net realisable values, and replacement values. That is why the asset-based approach, used in isolation, proves to be a challenging method to provide a fair valuation of the firm. For example, the book value of non-current assets is based on historical (sunk) costs and relatively arbitrary depreciation, which means that these amounts are unlikely to be relevant to any purchaser (or seller). The book values of net current assets (other than cash) might also not be relevant as inventory and receivables might require adjustment. What is more, each company has assets that are difficult to be valued in monetary terms, e.g., the reservoir of experience within the management team, the unique skills of the workforce, relationships with suppliers (Arnold & Lewis, 2019), or trade patterns and brands. Therefore, businesses are often worth more than their net asset value.
The usefulness of asset-backed approach to valuation
There are times, however, when asset values are beneficial. In some cases, the approach can be used if discounted income flow techniques are difficult to apply (Arnold & Lewis, 2019), e.g., property investment companies are primarily valued on the basis of their assets. Other examples include:
Investment trusts or investment funds; the share value of investment fund (e.g., mutual fund) is often calculated by a formula to determine the fund's net asset value. If shares of a fund or trust are traded on a stock exchange, its NAV is usually closely linked and similar to the market value.
Resource-based companies, e.g., oil companies, mineral extractors, or mining houses;
In the event of a firm's liquidation, net asset value figures indicate the amount of money shareholders may be eligible to receive if the company was liquidated. However, the liquidation value may not always be close to NAV;
Takeover bids, business analysts may use the asset-based approach in a takeover bid as shareholders may be reluctant to sell the company at less than the firm's total equity, i.e., below NAV.
This fragment of the article should be fully referenced to the book written by G. Arnold and D. Lewis (2019). Corporate Financial Management. 6th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/871263/Any thoughts?
Businesses need to be valued for several reasons, such as their purchase and sale, obtaining a listing, inheritance tax, and capital gains tax computations (ACCA, 2012). An essential aspect of any merger or takeover negotiation is the value placed on the shares of the businesses to be merged or acquired (Atrill, 2019). Other circumstances, including the firm's liquidation, will also require the asset-based valuation of such a firm.
Many investors, institutional or private, use various valuation methods to determine whether a company's share price in question is over-or undervalued. It is almost impossible to make such a statement solely based on an asset-based approach. However, it can help to analyse a company's financial health and is often used in other ratios, such as net asset value (NAV) per share or the book-to-market ratio.
Bibliography
ACCA (2012). Technical Article. Business Valuations [online]. Available at file:///C:/Users/user/Downloads/sa_feb12_f9_valuationsv2%20(3).pdf
Arnold, G. and Lewis, D. (2019). Corporate Financial Management. 6th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/871263/
Atrill, P. (2019). Financial Management for Decision Makers 9th edition. 9th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/1323529/
Damodaran, A. (n.d.).A Detour into Asset-Based Valuation [online]. Available at http://people.stern.nyu.edu/adamodar/pdfiles/valonlineslides/session19.pdf
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