CHAPTER 2: ASSET-BASED VALUATION 

ASSET-BASED VALUATION 

Asset has been defined by the industry as transactions that would yield future economic benefits as a
result of past transactions. Hence, the value of, investment opportunities is highly dependent on the
value that the asset will generate from now until the future. The value should also include all cash flows
that will be generated until the disposal of the asset. 

In practice, valuation is a sensitive and confidential activity in their portfolio management. Valuation
should be kept confidential to allow the company to negotiate a better position for them to acquire an
opportunity. Since the value of assets will depend on its ability to generate economic benefits, it is
more challenging to determine the value of a green field investment since value shall be based on pure
estimates compared to brown field investment. Green field investments are investments that started
from scratch while brown field investments are those opportunities that can be either partially or fully
Operational. Brown field investments are those already in the going concern State, as most businesses
are in the optimistic perspective that they will grow in the future. Therefore, they can be considered as
going concern business Opportunities (GCBOs). Going concern business opportunities are those
businesses that has a long term to infinite operational period. 

The advantage of GCBOs is that we already have a reference for their Performance - from its historical
performance or an existing business with a similar nature. With this, the risk indicators can be identified
easily and can be quantified accordingly. The Committee of Sponsoring Organization of the Treadway
Commission (COSO) suggests that risk management principles must be observed in doing businesses and
determining its value. It was noted in their report that the benefits of having a sound Enterprise-wide
Risk Management allows the company to: 

1. increase the opportunities;

2. facilitate management and identification of the risk factors that affect the business
3. identify or create cost-efficient opportunities
4. manage performance variability;
5. improve management and distribution of resources across the enterprise; and
6. make the business more resilient to abrupt changes.

The importance of identifying risks is to enable investors to quantify the impact of the risk and/or the
cost of managing these risks. Theoretically, asset value is dependent on the economic benefits (i.e. cash
flows) it gives. Since the entire company is driven by its asset base, the value of the company can be best
attributed to the value of its assets. The advantage of using this approach is it enables the analyst to
validate the firm value through the value of its assets. Some approaches may rely on the ability of the
asset to generate more revenues. However, this only focuses on the current and historical value of the
assets and will disregard the value it can generate in the future and may not fully represent the true
value of the assets. 

In asset-based valuation, familiarity with the generally accepted accounting principles is a key attribute
for an analyst to enable them to establish the value. Asset-based valuation can be used if the basis of
the value is concretely established and complete. Information required for asset-based valuation include
total value of the assets, the financing structure (i.e. total liabilities and total equity), classes of equity
and other sources of funding. 

Among the popular methods used to determine the value using assets as its bases are: (1) book value
method; (2) replacement value method; (3) reproduction value method; and (4) liquidation value
method. 

Book Value Method 

Book value can be defined as the value recorded in the accounting records of a company. The book
value is highly dependent on the value of the assets as declared in the audited financial statements,
particularly the balance sheet or the statement of financial position. International Accounting Standard
No. 1 requires that the statement of financial position to summarize the total value of its assets,
liabilities and equity of a firm. 

The assets are required to be categorized into current and non-current assets. Current assets are those
expected to be realized within the company’s normal operating cycle, expected to be realized within 12
months after these transactions were reported, or held primarily for the purpose of trading. Cash and
cash equivalents may also be included only if it is not restricted. On the other hand, assets wherein
benefits can be realized in more than 12 months are known as non-current assets. 

On the other hand, liabilities is also categorized as current and non-current. Current liabilities are
expected to be settled within the entity's normal operating cycle, due to be settled within 12 months,
held for the purpose of trading or if the company does not have ability to settle beyond 12 months. Non-
current liabilities are liabilities which are due to be settled longer than 12 months. 

In the book value method, the value of the enterprise is based on the book value of the assets less all
non-equity claims against it. Hence, the formula is as follows: 

Total Assets — Total Liabilities

Net Book Value of Asset=
Number of Outstanding Shares
To illustrate, Grape and Vines Corp. in the Year 20xx presented their statement of financial position with
the following balances: Current Assets is Php500 Million; Non-current Assets is Php1 Billion; Current
Liabilities ii Php200 Million; Non-current Liabilities is Php700 Million and the Outstanding shares is 1
Million. 

With the given information, the net book value of the assets is Php600 per share computed as follows: 

Current Assets Php 500,000,000

Non-current Assets 1,000,000,000

Total Assets Php 1,500,000,000

Current Liabilities Php 200,000,000

Non-current Liabilities 700,000,000

Total Liabilities Php 900,000,000

Php1,500,000,000 — Php 900,000,000

Net Book Value of Asset=
1,000,000 shares

Php600,000,000
Net Book Value of Asset=
1,000,000 shares
Net Book Value of Asset=Php 600 per share
The advantage of using book value method is that it provides a more transparent view on firm value and
is more verifiable since this is based in the figures reflected in the financial statements. However, the
book value only reflects historical value (only based on what is recorded in the accounting books) and
might not reflect the real value of the business now. 

Replacement Value Method 

While the book value method offers convenient determination of the company value, the limitation of
the book value method is that it does not account for the full value of the net assets now that would
result for overage or understatement of value of the net assets recorded in the books. The National
Association of Valuators and Analysts has defined the replacement cost as the cost of similar assets that
have the nearest equivalent value as of the valuation date. 

Under the replacement value method, the value of the individual assets shall be adjusted to reflect the
relative value or cost equivalent to replace that asset. The following are the factors that can affect the
replacement value of an asset: 

 Age of the asset - It is important to know how old the asset is. This will enable the valuator to
determine the costs related in order to upkeep a similarly aged asset and whether assets with
similar engineering design are still available in the market. 
 Size of the assets - This is important for fixed assets particularly real property where assets of
the similar size will be compared. Some analysts find that the assets can produce the same
volume for the assets of the same size. 
 Competitive advantage of the asset - Assets which have distinct characteristics are hard to
replace. However, the characteristics and capabilities of the distinct asset might be found in
similar, separate assets. Some valuators combine the value of the similar, separate assets that
can perform the function of the distinct asset being valued. 

There is a specific discipline in determining the replacement value. Appraisers have their own technique
to determine the replacement value. Insurance companies use the replacement value in determining
the appropriate insurance premium to be charged to their clients. For instance, a company owns a
building with a book value of Php 5 Million, and the estimated replacement cost is Php6 Million. The
insurer can offer a premium to cover the insurance at Php6 Million. This is the most prudent approach
for a company. 
However, if the company opted to get a coverage lower than its replacement value, for example Php4
Million, the insurer will only reimburse the amount cover and the company will be the one to cover for
the Php2 Million difference. Note that value that will be shouldered is not Php 1 Million (Php5 Million
less Php4 Million) but instead Php2 Million since the asset can no longer be replaced now at Php 5
Million. 

The value of the equity using the replacement value method is computed using the formula 

Net Book Value ± Replacement Adjustment

Replacement Value per Share=
Outstanding Shares
To illustrate, following through the given information for Grapes and Vines Corp. suppose that 50% of
the non-current assets has an estimated replacement value of 150% of is recorded net book value while
the remaining half has estimated replacement value of 75% of their recorded net book value. With the
given information, the equity value is adjusted: 

1. Calculate the replacement value of the affected items. 

Since the values presented are the one presented in the statement of financial position, it is
assumed that it is the net book value of the non-current assets. 

50% of Non-current Assets - 150% of the net book value

Non-current Assets Php 1,000,000,000 
% of affected item 50%
50% of the Non-current Assets Php 500,000,000
Premium on Replacement 150%
Adjusted Non-Current Assets (A) Php 750,000,000

50% of Non-current Assets is 75% of the net book value

Non-current Assets Php 1,000,000,000
% of affected item 50%
50% of the Non-current Assets Php 500,000,000
Discount on Replacement 75%
Adjusted Non-Current Assets (B) Php 375,000,000

Total Adjusted Non-current Assets

Adjusted Non-Current Assets (A) Php 750,000,000
Adjusted Non-Current Assets (B) 375,000,000 
Total Adjusted Non-current Assets Php1,125,000,000 

2. Add back the unadjusted components 

Total Adjusted Non-current Assets Php1,125,000,000

Add: Current Assets 500,000,000
Total Assets — Replacement Value Php1,625,000,000 
 3. Apply the Replacement Value Formula

Php1,625,000,000−Php900,000,000
Replacement Value=  
1,000,000 shares
Php725,000,000
Replacement Value=
1,000,000
Replacement Value=Php 725 per share
Reproduction Value Method 

In some instances, no external information is available that can serve as basis for replacement cost of
assets that are highly specialized in nature. In this case, reproduction value is used instead.
Reproduction value is an estimate of cost of reproducing, creating, developing or manufacturing a
similar asset. For example, the firm has an internally constructed equipment costing Php 1 Million that
processes 500 tons of inventory. After few years of using the equipment, the firm estimated that
developing another asset with similar capability i.e. to generate 500 tons of inventory will cost Php 1.3
Million. 

The reproduction value method requires reproduction cost analysis which is internally done by
companies especially if the assets are internally developed. Hence, this method is useful when
calculating the value of new or start-up businesses, ventures that use specialized equipment or assets,
firms that are heavily dependent on intangible assets and those with limited market information. While
this is a convenient approach, the challenge of using reproduction value method is the ability to validate
the reasonableness of the value calculated since there are only limited sources of comparators
and benchmark information that can be used. 

Steps in determining the equity value using the reproduction value method are as follows: 

1. Conduct reproduction costs analysis on all assets 

2. Adjust the book values to reproduction costs values (similar as replacement value) 
3. Apply the replacement value formula using the figures calculated in the preceding step. 

To illustrate using the information of Grapes and Vines Corp., supposed that it was noted that the 80%
of the total noncurrent assets are cheaper by 90% of the book value when reproduced. 20% of the total
noncurrent assets are comprised of goodwill which upon testing was proven to be valued correctly, 

1. Conduct reproduction cost analysis to all assets 80% of the Total Noncurrent Assets if
reproduced is equal to 90% of its value 

Non-current Assets Php 1,000,000,000

% of affected item 80%
Php 800,000,000 

Since the remaining 20% or Php 200 Million is goodwill and already in its proper value, it will not
be adjusted. 
 2. Adjust the book value to reproduction costs 

Non-current Assets Php 800,000,000

Reproduction Cost Estimate % 90%
Reproduction Cost Php 720,000,000 

Non-Current Assets — Reproduction Cost Php 720,000,000 

Add: Goodwill 200,000,000
Total Non-current Assets Php 920,000,000
Add: Current Assets 500,000,000
Total Assets Php1,420,000,000 

3. Apply the replacement value formula using the figures calculated in the preceding step.

Php 1,420,000,000−Php 900,000,000

Reproduction value=
1,000,000 shares

Php 520,000,000
Reproduction value=
1,000,000 shares

Reproduction value=Php520 per share

Liquidation Value Method 

Liquidation value method is an equity valuation approach that considers the salvage value as the value
of the asset. This assumes that the reasonable value for the company to be purchased is the amount
which the investors will realize in the end of its life or the value of the when it is terminated. While the
value it provides is the most conservative, the limitation of this approach is that the future value is not
fully incorporated in the calculated equity value. This method will be further discussed in the next
chapter.