Valuation of Assets is a process of determining the assets fair value using various valuation models or techniques.
An asset is a resource, which creates present and future benefits for an individual, corporate, etc.. Assets are lodged with an economic value. In terms of accounting treatment, assets are reported on the company’s balance sheet, which increases the individual and corporates value in the present and the future. Assets include land, building, plant and machinery, securities, etc., and segregated into various buckets like current assets and non-current assets, tangible and intangible assets, etc.
Current Assets: Current assets are short term assets, which can be converted into liquid cash within a year such as inventory, cash, receivables, etc.
Non-current Assets: Non-current assets are long-term assets, which cannot be easily converted into liquid cash within one-year, including land, building, plant and machinery, etc. Further, assets also include financial assets and intangible assets.
Financial Assets: When an individual or any corporate invests in securities and assets of other institutions such as stocks, bonds, etc., are known as financial assets. The valuations of financial assets totally depend on the categorisation of investment.
Intangible Assets: Intangible assets are an economic resource of an individual, corporate, etc., which do not have a physical appearance. The intangible assets include goodwill, patent, trademark, copyright and so on and so forth. The valuation and accounting treatment totally depends on the type of asset, as it can be tested for impairment every year or amortised.
Moving to the valuation of an asset. Asset valuation is the process, by which, an investor recognises the fair market value of an asset. Asset valuation comprises of two measurements, such as subjective and objective. For performing the valuation of an asset, it is necessary to calculate the net asset value.
Net Asset Value:
The net asset value of the firm can be calculated by subtracting total liabilities from the book value of the total assets on the balance sheet of the company. Tangible assets should be reported after subtracting accumulated depreciation. It is a process of cumulation of depreciation. For example, if a company purchases an asset for $100,000 with a useful life of 10 years and a salvage value of $10,000 and following the straight-line depreciation method. The amount for depreciation can be calculated as subtracting salvage value ($10000) from buying price ($100,000) divided by useful life (10 years). The depreciation amount of asset is $9,000 for a year. This implies that the asset will be depreciated by an amount of $9000 for 10 years. Every single year, the accumulated depreciation increases by $9,000. Conclusively, at the end of six years, the expense for depreciation is still $9,000, but accumulated depreciation reaches to $54,000.
The net asset value can also be said as net tangible assets. To reach the amount of net tangible asset, it is first required to subtract all intangible assets, such as patents, copyright, trademarks and goodwill as well as the par value of the preferred shares from total assets or net tangible assets. Let’s move towards the calculation of NTA. Let’s assume the company has the following:
- Total Assets: $2 million
- Total Liabilities: $200,000
- Intangible Assets: $200,000
The net tangible asset of the company amounts to $1,600,000, which has been calculated by subtracting total liabilities and intangible assets from the total asset of the company. When it comes to the merits and demerits of net tangible assets, the above prescribed method enables the company to analyse its asset position. Moreover, the usefulness of the calculation of net tangible assets differs throughout the industries. A medical device manufacturer has high levels of valuable intangible assets. In terms of the calculation of net tangible assets, the return on asset can be a truer measure. The return on asset (ROA) is a profitability measure, which implies how profitable the company is in relation to its total assets on the books. It also represents the efficiency of the company’s management is using the assets in deriving economic benefits. ROA of an organisation can be calculated by dividing the net income of the company by total assets. Let’s suppose an organisation have commenced the business with total assets of $25,000 and earned $2,500 within a year then the return on assets stood at 10%.
Moving ahead to the comparison of ROA with previous years. If an organisation report return on asset of 10% in the current financial year compared to 8% ROA in the previous year, this implies that the company is deriving better profits from its assets. A higher ROA showcases that the company is deriving better profits on a Y-o-Y basis.
Apart from the net asset value method, there are other methods in relation to the valuation of an assets, such as absolute and relative valuation. The absolute method includes discounted cash flow and discounted dividend method. In relative valuation, the investor performs the valuation by using price multiples.
Discounted Cash Flow Method: The discounted cash flow method is generally performed for valuation of asset for a long-term period. The major factor to be used in DCF is the free cash flow. The discounted cash flow method is performed to evaluate the company’s present day value on the back of projections of how much money will be generated in the future. The objective behind discounted cash flow is to calculate how much an investor would receive from his/her current investment by adjusting the time value of the money. The time value of money means that a dollar today is worth more than a dollar tomorrow.
Let’s suppose an individual is saving $100 in his savings account with 4% annual interest, at the end of the year, the value of $100 will be $104.
Discounted cash flow is calculated by cash flows and discounting factor, i.e. WACC (Weighted average cost of capital). The WACC is a calculation of the company’s cost of capital, which includes preferred stock, common stock, bonds and long-term debts. The formula for WACC is as follows:
WACC = (E/V* Re) +(D/V*Rd (1-Tc)), where
Re = Total Cost of Equity
Rd = Total Cost of Debt
E = Market Value of Total Equity
D = Market Value of Total Debt
V = Total Market Value of the company’s Combined Debt and Equity or E + D
E/V = Equity Portion of Total Financing
D/V = Debt Portion of Total Financing
Tc = Income Tax Rate.
When it comes to the valuation of an asset by relative valuation method, the relative valuation model compares the same industry data on multiples factor, such as price-to-earnings ratio, price-to-book value ratio and price-to-cash flow ratio. PE ratio of the company represents how much market is willing to pay for the organisation’s earnings. It is derived by dividing the current market price per share by EPS (Earnings Per Share). It basically reveals how much an investor must pay in order to earn $1 from the company. For example, the company has a price-to-earnings ratio of 10, which indicates that the investor is willing to pay $10 for earning $1 of current earnings.
EV/Sales is also used to perform the relative valuation. The EV/ sales multiples include a comparison of enterprise value and annual sales. It is calculated by the formula
EV/ Sales = (Market Capitalisation + Debt – Cash and Cash Equivalents)/Annual Sales.
The valuation of assets is driven by various parameters, such as the underlying cost of funds, the performance of the asset class as compared to other assets, the general market sentiments, the economic scenario both at the micro and macro level, etc. Thus, it would not be a stretch to say that the valuation of an asset is part science and part art.
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