Adjusted Book Value Method of Corporate Valuation

In recent years, management consulting firms have started offering companies advice on how to increase value. This has been possible because of the fear of hostile takeovers. Companies have increasingly turned to “value consultants” to tell them how to restructure, increase value, and avoid being taken over. The consultants suggestions have often provided the basis for the restructuring of these firms. The value of a firm can be directly related to decisions that it makes: on which projects it takes, on how it finances them, and on its dividend policy. Understanding this relationship is key to making value increasing decisions and to sensible financial restructuring.

Adjusted Book Value Approach to Corporate Valuation

The adjusted book value method of corporate valuation involves estimation of the market value of the assets and liabilities of the firm as a going concern. It is a pointer to the liquidation value of the firm. It is, however, distinct from the conventional book value method. The conventional book value approach relies on the historical book value of the assets and liabilities. But in this adjusted book value method of corporate valuation, the valuation of the assets and liabilities are taken at their fair market value.

Valuation of Tangible Assets

The adjusted book value method of corporate valuation begins with valuation of all the assets of the firm. Fixed assets constitute substantial portion of the asset side of the balance sheet in capital intensive companies. Land is valued at its current market price. Buildings are normally valued at replacement cost. However appropriate allowances are to be made for depreciation and deterioration in its conditions. Similarly plant & machinery, capital equipments, furniture, fixtures, etc. are to be valued at fixed costs net of depreciation and allowances for deterioration in conditions. An alternative method of valuing plant & machinery involves estimation of the prevailing market price of similar used (second-hand) machinery and adding the cost of transportation and erection. The other major block on the asset side of the balance sheet is current assets. The principal components of current assets are inventory, debtors and cash. The inventory is valued depending upon its nature; the raw materials are to be valued at the rates of the latest orders; the finished goods at the current realizable sale value after deducting provisions for packing, transportation, selling costs, etc. The work-in-process can be valued either based on the cost i.e. cost of materials plus processing costs incurred or based on the sales price i.e. sale price of the finished product less cost incurred to convert the work-in-progress into sales. Debtors are generally valued at their book value. However, allowances should be made for any doubtful debts. Valuation of cash (including balances with bank) does not need any great expertise. Miscellaneous current assets like income accrued but not due, prepaid expenses, deposits made etc. are to be taken at their book value. Non-operating assets like investments, surplus land, staff quarters, etc. are generally valued at their fair market value.

Valuation of Intangible Assets

The valuation of intangible assets like brands, goodwill, patents, trademarks & copyrights, distribution channel, etc. is a controversial area of valuation. Several major companies (consumer goods in particular) believe that brands are its most valuable assets.  As intangibles have significant financial value, their absence from the valuation distorts the true financial position of a company. Hence in order to ensure that the valuation of a company is reflective of its true intrinsic worth it has become necessary for companies to determine the values of their brands.

There is a large element of subjectivity in the process of valuation of intangibles. The two popular methods of valuing intangibles are given below.

1. Earnings Valuation Method: This method of valuation is widely accepted in most markets around the world. The value of an intangible like any other asset is equal to the present value of the future earnings attributable to it. This is a two-staged process involving

  1. Determining the future earnings attributable to the intangible asset;
  2. Applying an appropriate multiplier to determine its present value.

The main drawback of this approach is that the future projections of the earnings may be optimistic. Further the process of determining the multiplier is highly subjective. Due care has to be taken for the above factors, failing which the intangible asset may be overvalued. Unscrupulous companies may possibly overvalue the intangibles and use brand values as a tool for window dressing.

2. Cost Method: This method involves stating the value of the intangible asset at its cost to the company. This is relatively easy when the intangible asset is acquired. The money paid to buy the brands can be directly stated. It is more difficult to value the brand when the intangible asset has been developed in-house by the company. The methodology involves determining the cost incurred in developing the intangible asset. The process of identification of the the costs incurred is characterized by a great degree of subjectivity. This may have a significant impact on the final valuation.

Valuation of Liabilities

The valuation of liabilities is relatively simple. It must be noted that share capital, reserves and surpluses are not included in the valuation. Only liabilities owed to outsiders are to be considered. All long-term debt like loans, bonds, etc. are to be valued at their present value using the standard bond valuation model. This involves computing the present value of the debt servicing (both principal and interest payments) by applying an appropriate discount rate. Current liabilities include amount due to creditors, short-term borrowings, provision for taxes, accrued expenses, advance payment received, etc. Normally such current liabilities and provisions are taken at their book value.

Valuation of the Firm

The ownership value of a firm is the difference between the value of the assets (both tangible and intangible) and the value of the liabilities. Normally no premium is added for control as assets and liabilities are taken at their economic values. On the other hand, a discount may be necessary to factor in the marketability element. The market for some of the assets may be illiquid or may fetch a slightly lesser price if the buyer does not perceive as much value of the asset to his business. Hence a discount factor may be applied.