What is Asset Valuation?

Any business has assets and liabilities. Assets are those that a company owns. Liabilities are those that the company owes. Asset valuation is the process of determining the fair market value of the different types and classes of assets held by a company. There are several methods of performing asset valuation, which will be covered as follows. But first, it is important to understand the different categories of assets that are held by a company. They can be broadly classified into the following:

• Tangible assets: Tangible assets are those assets that can be physically seen and observed such as inventory, land and real estate (fixed asset), buildings (fixed asset), equipment and machinery (fixed asset), vehicles, computer equipment, furniture, and fixtures, receivables, cash, and bank balances. Capitalization occurs when expenses related to assets are added to the cost of the asset and written off over time as depreciation. Most items on the list above are expected to depreciate over time, and asset valuation considers these.
• Intangible assets: Intangible assets are those other assets that cannot be physically seen and touched and have different methods of valuation. These include goodwill, intellectual property, trade secrets, copyright, trademarks, patents, etc. There are guidelines available in Accounting Standards (which vary from country to country based on broad accounting principles) such as US GAAP (Generally Accepted Accounting Principles followed in the United States), IFRS (International Financial Reporting Standards), that discuss methods of valuation based on the industry and structure of the company. Tangible assets have different methods of valuation from intangible assets. Let us discuss the two separately.

Tangible assets

It is important to determine the Net Book Value (NBV) of the tangible assets, which can be computed by ascertaining the difference between the historical cost and accumulated depreciation of the tangible assets. It is important to consider economic factors such as bad debts, discounting of stock, and changes in the value of some assets such as land appreciation.

Depreciation of assets is a critical factor in determining the present book value of assets as assets such as buildings, equipment, computer machinery, vehicles experience wear and tear and risk the reality of obsolescence. Depreciation is charged as a cost to the profit and loss account or the income statement (part of the financial statements) and can also be claimed (with a different computation) as part of tax planning.

For some assets such as real estate and stocks and bonds, there are different methods of valuation such as Discounted models that include cash flow and dividend projections and considers the net present value (NPV) of the assets.

The different methods for asset-based valuation are discussed below:

Total asset method

The Total Asset Method of asset valuation is simply the difference between accumulated assets and liabilities. This represents a balance sheet where each item is assigned a value based on the metrics discussed above.

Excess earnings method

The Excess Earnings Method is an asset valuation method where the resources of the company (net tangible assets) are valued by its earnings, which are also used to compute the value of goodwill.

Appraisal method

The Appraisal Method is the evaluation of the performance of a company’s assets against a set of criteria. This form of asset valuation evaluation is performed by a professional appraiser who assigns a particular cost to each asset, based on various factors, such as the income generated by such asset as against its original investment, and comparison to the fair market value of other assets in a similar category.

For stocks and shares, as discussed above, there are other measures of valuation as well such as the dividend discount model and the discounted free cash flow model, where the predicted dividends and cash flow are discounted by dividends and the weighted average of the cost of capital, respectively to arrive at the Net Present Value (NPV).

Intangible assets

Intangible assets are valued differently from tangible assets as they cannot be physically monitored, but they significantly contribute to the upkeep of the business. They are subject to amortization from their acquired price, based on their lifespan and other factors.

As a rule of thumb, intangible assets are valued as the difference between their market value and their book value. However, this has been known to be an inaccurate measure since the market value is volatile and gives an unreal picture of the actual value. Intangible assets are based on the economic value or their Calculated Intangible Value (CIV) that is computed as follows, which considers other factors as well for its computation.

Here are the steps:

1. First, calculate the average earnings for the last three years (pre-tax) and the average value of the tangible assets.
2. Compute the Return on Assets (ROA) of the company and industry average ROA for the three years as mentioned for the pre-tax earnings.
3. Multiply the industry average ROA and the average tangible assets to obtain the industry earnings.
4. Subtract the average pretax earnings from the industry earnings from the previous steps.
5. Compute the average tax for the last three years and apply the percentage on the excess earnings from the previous step.
6. Finally, discounting the cost of capital, compute the net present value of the post-tax excess return. This is the value of the CIV.

Why is the Valuation of Assets Important?

Valuation of assets is an important exercise for various reasons. Some of them are listed below:

Robust accounting system

Valuation of assets regularly ensures a true and fair representation of the books of accounts which also helps with the regular audit procedures. This is especially important to a shareholder who wishes to understand the financial position of the company.

Mergers & acquisitions

When a company is under the process of a Merger & Acquisition (M&A), it is imperative to undertake a valuation process to understand the value of the companies entering into the M&A. 

Taxation

Taxes are a very important criterion to assimilate the fair value of assets and undertake the valuation process. By computing the right value of assets, the right amount of tax can be computed accurately.

Technical Language/Glossary

• US GAAP: Generally Accepted Accounting Principles (applicable in the United States)
• IFRS: International Financial Reporting Standards
• Ind AS: Indian Accounting Standards (applicable in India)

Common Mistakes and Pitfalls

Some of the common possible errors while performing the valuation of assets are as follows:

• Inaccurately computing the value of assets by the market-based fair value method, or incorrectly taking the wrong historical cost (investment). 
• Inaccurate computation of liability, leading to a miscalculation of net assets in the balance sheet.
• Inaccurate computation of depreciation or accumulated depreciation, which could impair the overall computation of the net value of the assets.
• While computing the NPV of the assets, one could take the wrong discounting rate or projected cash flow or dividends, which could lead to incorrect asset valuation. 
• While computing the CIV, one can always make the mistake of wrongly computing any of the elements of the computation such as average pre-tax earnings, or ROA, or ROA industry average, or average value of tangible assets, or the average tax computation. 

One must always watch out for the above errors, as even one mistake in the computation of an element could throw the entire asset valuation process haywire. 

Context and Applications

Assets are the most valuable to a company, and the appropriate valuation of the assets is imperative to the fair measurement of the company’s success. Liability is what the company owes its stakeholders and them along with equity, balance the assets on a balance sheet. If it is a publicly listed company, then the valuation of the assets also determines the value of the company’s share price.

This topic is significant in the professional exams for both undergraduate and graduate courses that have accounting and commerce at their core. This may be especially applicable for:

• B. Com
• M.Com
• MBA (Finance)

Professional certifications including:

• Chartered Accountancy;
• Certified Public Accountant (CPA);
• Association of Chartered Certified Accountants (ACCA);
• Certified Internal Auditor (CIA)