Asset based theories start from the premise that the success of a business is its ability to accumulate assets, and it is because of those assets that the firm can generate income. Therefore, it is the value of the assets that comprises the value of the firm (Pricer & Johnson, 1997). Asset theories also assume that book value is generally a good measure of market value of small firms. Further, because assets generate income, the value of a firm should decrease as its assets’ remaining lives diminish. There are a variety of asset-based methods that may be used to value firms.
The book value method calculates the value of a firm based on its unadjusted accounting data. The firm’s value is the sum of its assets. Several related book value techniques were discussed by Robert Pricer and Alec Johnson in the Journal of Small Business Management (1997). Pricer and Johnson said the drawbacks to book value are: the extent to which relevant data is ignored; the varying nature of a firm’s earning potential; and the lack of consideration of the market value of a firm’s assets.
Adjusted book value seeks to eliminate the most glaring problems with book value by allowing for reasonable and justifiable adjustments to the asset accounting data, but still does not allow for line adjustments or consider income potential. The liquidation value technique values the assets at the price that they could command in a situation that required their quick sale. This is a useful baseline for firm value, but does not consider ongoing business characteristics or values. Replacement value considers the cost that would be incurred if a firm were to acquire all of the assets currently owned by the firm being evaluated. This method is good for insurance purposes but still does not consider the earnings potential of the firm.
Finally, the net assets method is the most commonly used asset based method of venture valuation. This calculates the value of a firm as assets less liabilities. The result is often higher than the book value (Siegel & Gavron, 1994). This type of valuation may be appropriate for a firm whose value is closely linked to its assets, such as property holding companies and investment firms (IPEV Board, 2008). This method involves valuing all of the firm’s assets and liabilities at a present value based on the asset’s future income generating potential or liquidation value, depending on the circumstances (Jenkins, 2006). The method for arriving at the rate of required return for discounting purposes will be discussed in depth in the income based valuation section. After the assets and liabilities have been assigned appropriate values, a liquidity discount may be applied to correct for the cost of not having the capital invested readily available.
It is important to adjust for and include intangible assets when using asset based valuation methods. Intangible assets include assets that are problematic to value because they are not physical objects. There is still a need to value these assets, however, because of the growing importance of their role in business (Olsen, Halliwell & Gray, 2007). The process of valuing these assets is an important part of business valuation and should be examined in any valuation process because intangible assets add great value to a firm’s bottom line.
Intangible assets and their valuation were discussed in depth by Marc Olsen Michael Halliwell and Robert Gray in the Journal of Accountancy and mentioned the following considerations (2007). Intangible assets may include assets related to marketing, customers, artistic creations, contracts, expertise, or technology. The first step in valuing intangible assets is clearly identifying them. These assets are covered by the Financial Accounting Standards Board Statements 141 and 142 which define methods for valuing them, including allocating to them the total consideration paid for the assets. This establishes their fair value. Additionally, an asset’s value may be calculated using: the discounted value of its associated income stream; a calculation of probable value of relief from royalties associated with the asset; comparable transactions in the market; and the costs avoided by the firm through the creation of the asset instead of purchasing it. It is important to consider the valuation of intangible assets in any valuation method, but it is particularly important in the asset-based methods.
Asset based methods do not consider that a firm is more than the sum of its assets. Firm assets are combined with intangible elements of the firm to create synergies, thus increasing the value of the firm (Harrison, 2003). In order to properly consider the effects of continued earnings on the value of the firm, various earnings based theories have been developed which vary in complexity reflecting the number of variables and influencing factors considered.