Any company’s worth can simply be worth of its assets. Asset value is the first level of assessment that can represent the baseline of the company’s worth. Additional value a company can create by earning a rate of return more than its cost on the existing and new capital. How do we understand the value of a company based on assets?
Any company has two kinds of assets i.e. current and fixed. Most of the current assets represent their worth. However, fixed assets may not hold the value as shown in the balance sheet.
There are two approaches to address this:
Liquidation value
This is the value assuming the company is shutting down. This approach is suitable when the company is going under liquidation, and the analyst is trying to assess whether to buy distressed assets or not.
Here is a sample balance sheet that we can use to assess liquidation value:
Cash and marketable securities are taken the same as mentioned in the balance sheet. Account receivable will probably not be recovered in total, but we can estimate that we can realize 85% of the stated amount since it is trade debt. Inventory valuation depends upon the type of inventories. More specialized inventory will fetch a lower amount. The same logic applies to plant, property and equipment as well. I have assumed 50% inventory realization and 45% plant, property and equipment realization.
Goodwill will not fetch anything, and deferred taxes will get adjusted with the liabilities.
Account payable and accrued expenses amount to only 2,667. However, after paying for these liabilities, 12,220 will still be left as liabilities. Given the company's condition, if a steep discount is available on debt, investment in debt may be evaluated. However, if a discount is not available, then you should keep yourself away from this company.
Reproduction value
Suppose a company operates in a viable industry. In that case, the economic value of the assets is the company’s reproduction cost, i.e. what a competitor should spend to get into this business.
Cash and marketable securities do not require any adjustment. A new company may not be as efficient in getting the payments from the customer. Therefore, adjusting for allowances in accounts receivable is a better idea. Valuing inventory can be a daunting exercise. Based on the industry, analysis needs to be performed, mainly inventory / COGS, to understand any pilling up of inventory.
Additionally, suppose the firm uses the LIFO method of inventory reporting. In that case, the LIFO reserve is added back because the new firm may not be able to source inventory at last year’s price. Plant, property and equipment may be one item, but they are three. Land usually appreciates; assessing the market value of the land is a better idea. Plant and building use depreciation allowance that may not represent the accurate picture. The competitor has to pay a lot more than what is usually shown on the balance sheet. The adjustment made in the equipment value may be up or down, depending upon the industry, but it is not so massive. The value of goodwill needs to be understood rather than relying on the balance sheet number. Goodwill is an accounting entry, but a company may enjoy a premium due to its reputation. This may be linked with the R&D expense of the company. How many years will the product take to establish its market in a new company's layout?
Most of the quality companies may not be available at asset value levels. However, once in a decade events such Global Economic Crisis of 2008, Pandemic crisis of 2020 may provide window to invest based on the asset value.
Disclaimers
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Details of the advisor
Advisor: Ankur Kapur
SEBI RIA No.: INA100001406
BASL Member ID: BASL1337