OCW041: Valuing of Assets

Basic Components of Asset Valuation

Assets are valued using absolute value, relative value, or option pricing models, which require different inputs.

Learning Objectives

Differentiate between the absolute value, relative value, fair value and option pricing methods of valuing an asset

Key Takeaways

Key Points

  • Absolute value models that determine the present value of an asset ‘s expected future cash flows. These kinds of models take two general forms: multi-period models ( discounted cash flow models) or single-period models. These models rely on mathematics rather than price observation.
  • Relative value models determine value based on the observation of market prices of similar assets.
  • Option pricing models are used for certain types of financial assets (e.g., warrants, put options, call options, employee stock options, investments with embedded options such as a callable bond ) and are a complex present value model.
  • The book value of an asset is its recorded cost less accumulated depreciation. An old asset’s book value is usually not a valid indication of the new asset’s fair market value. However, if a better basis is not available, a firm could use the book value of the old asset.
  • An appraised value is an expert’s opinion of an item’s fair market price if the item were sold. Appraisals are used often to value works of art, rare books, and antiques.

Key Terms

  • valuation: The process of estimating the market value of a financial asset or liability.
  • liability: An obligation, debt or responsibility owed to someone.
  • asset: Something or someone of any value; any portion of one’s property or effects so considered

Basic Asset Valuation

In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

Overview

Valuation of financial assets is done using one or more of these types of models:

  • Absolute value models that determine the present value of an asset’s expected future cash flows. These kinds of models take two general forms: multi-period models such as discounted cash flow models or single-period models such as the Gordon model. These models rely on mathematics rather than price observation.
  • Relative value models determine value based on the observation of market prices of similar assets.
  • Option pricing models are used for certain types of financial assets (e.g., warrants, put/call options, employee stock options, investments with embedded options such as a callable bond) and are a complex present value model. The most common option pricing models are the Black–Scholes-Merton models and lattice models.
  • Fair value is used in accordance with US GAAP (FAS 157), where fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for fixed assets carried at historical cost (less accumulated depreciation), the fair value of the asset is not used.

Common terms for the value of an asset or liability are fair market value, fair value, and intrinsic value. The meanings of these terms differ. For instance, when an analyst believes a stock’s intrinsic value is greater (less) than its market price, an analyst makes a “buy” (“sell”) recommendation. Moreover, an asset’s intrinsic value may be subject to personal opinion and vary among analysts.

When a plant asset is purchased for cash, its acquisition cost is simply the agreed on cash price. However, when a business acquires plant assets in exchange for other non-cash assets (shares of stock, a customer’s note, or a tract of land) or as gifts, it is more difficult to establish a cash price. This section discusses three possible asset valuation bases.


Emerging Values: Environmentalism and Green Energy: Image of an energy plant.

The general rule on non-cash exchanges is to value the non-cash asset received at its fair market value or the fair market value of what was given up, whichever is more clearly evident. The reason for not using the book value of the old asset to value the new asset is that the asset being given up is often carried in the accounting records at historical cost. In the case of a fixed asset, its value on the balance sheet is historical cost less accumulated depreciation, or book value. Neither amount may adequately represent the actual fair market value of either asset. Therefore, if the fair market value of one asset is clearly evident, a firm should record this amount for the new asset at the time of the exchange.

Appraised Value

Sometimes, neither of the items exchanged has a clearly determinable fair market value. Then, accountants record exchanges of items at their appraised values as determined by a professional appraiser. An appraised value is an expert’s opinion of an item’s fair market price if the item were sold. Appraisals are used often to value works of art, rare books, antiques, and real estate.

Book Value

The book value of a fixed asset asset is its recorded cost less accumulated depreciation. An old asset’s book value is usually not a valid indication of the new asset’s fair market value. However, if a better basis is not available, a firm could use the book value of the old asset.

Occasionally, a company receives an asset without giving up anything for it. For example, to attract industry to an area and provide jobs for local residents, a city may give a company a tract of land on which to build a factory. Although such a gift costs the recipient company nothing, it usually records the asset (land) at its fair market value. Accountants record gifts of plant assets at fair market value to provide information on all assets owned by the company. Omitting some assets may make information provided misleading. They would credit assets received as gifts to a stockholders’ equity account titled Paid-in Capital—Donations.

Additional Factors to Consider

There are additional factors to consider when valuing a business including competition, management stability, etc.

Learning Objectives

Key Takeaways

Key Points

  • An important aspect of company valuation is determined when examining it in comparison to competitors. The company’s relative size compared with other businesses in its industry, relative product or service quality, etc. are important.
  • When looking at management stability as a part of business valuation, one must consider if the management is skilled and experienced enough to maintain the company’s position and, potentially, improve it in the future.
  • Consideration of financial strength entails a number of ratios, including a company’s total debt to assets, long-term debt to equity, current and quick ratios, interest coverage, and operating cycle.
  • The book value of an asset is its recorded cost less accumulated depreciation. An old asset’s book value is usually not a valid indication of the new asset’s fair market value. However, if a better basis is not available, a firm could use the book value of the old asset.
  • An appraised value is an expert’s opinion of an item’s fair market price if the item were sold. Appraisals are used often to value works of art, rare books, and antiques.

Key Terms

  • competitor: A person or organization against whom one is competing.
  • management: Administration; the process or practice of managing.
  • intangible: Incapable of being perceived by the senses; incorporeal.

Additional Factors to Consider

Competition

An important aspect of company valuation is determined when examining it in comparison to competitors. The company’s relative size compared with other businesses in its industry, relative product or service quality, product or service differentiation from others in the industry, market strengths, market size and share, competitiveness within its industry in terms of price and reputation, and copyright or patent protection of its products are all important in this examination.

  • The most narrow form is direct competition (also called “category competition” or “brand competition”), where products which perform the same function compete against each other. For example, one brand of pick-up trucks competes with several other brands of pick-up trucks. Sometimes, two companies are rivals, and one adds new products to their line, which leads to the other company distributing the same new things, and in this manner they compete.
  • The next form is substitute or indirect competition, where products which are close substitutes for one another compete. For example, butter competes with margarine, mayonnaise, and other various sauces and spreads.
  • The broadest form of competition is typically called “budget competition. ” Included in this category is anything on which the consumer might want to spend their available money. For example, a family which has $20,000 available may choose to spend it on many different items, which can all be seen as competing with each other for the family’s expenditure. This form of competition is also sometimes described as a competition of “share of wallet. “

Management Ability

When examining this factor as a part of business valuation, one must consider if the management is skilled and experienced enough to maintain the company’s position, and potentially improve it in the future. Several factors can indicate management ability: accounts receivable, inventory, fixed assets, and total asset turnover; employee turnover; condition of the facilities; family involvement, if any; quality of books and records; and sales, as well as gross and operating profit.

Financial Strength

Consideration of financial strength entails a number of ratios, including a company’s total debt to assets, long-term debt to equity, current and quick ratios, interest coverage, and operating cycle.

  1. Total debt to assets: total debt/total assets or total liability /total assets
  2. Long term debt to equity: long term debt(liabilities)/equity
  3. Current ratio: current assets/current liabilities

Profitability and Stability of Earnings

In accounting, profit is the difference between the purchase and the component costs of delivered goods and/or services and any operating or other expenses. This can help determine the financial stability of a company when viewing its profitability during its operating history, including the number of years the company has been in business, its sales and earnings trends, the life cycle of the industry as a whole, and returns on sales, assets and equity.

Other Factors

Along with the aforementioned considerations, a valuator must also keep in mind the economic conditions in which the company is operating, including the broad industry outlook and the impact of various IRS rulings and court cases that may affect the company’s value.

In addition, the valuator must analyze the values of comparable companies to determine their relationship to the company’s value. Intangible factors such as goodwill and non-compete agreements are important as well.

Finally, the valuator needs to consider the discount or capitalization rate of the company, specify what percentage of the company is being valued, and take into account any marketability or minority interest discounts.

Perhaps the most difficult part of the entire process is knowing how to combine all of these factors in a meaningful way to reach a value that will withstand any challenges by potential buyers, the IRS, dissatisfied partners or others.

Fair value should also be a consideration when valuing certain assets. Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for fixed assets carried at historical cost (less accumulated depreciation), the fair value of the asset is not used.

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Apple is a successful company with considerable goodwill.: This is an example of an additional factor beyond book value that contributes to the overall valuation of a company.

Valuing Repairs, Maintenance, and Additions

Improvements to existing plant assets are capital expenditures because they increase the quality of services obtained from the asset.

Learning Objectives

Explain what a capital expenditure is and how a company would account for it.

Key Takeaways

Key Points

  • Because betterments or improvements add to the service-rendering ability of assets, firms charge them to the asset accounts.
  • Occasionally, expenditures made on plant assets extend the quantity of services beyond the original estimate but do not improve the quality of the services. Since these expenditures benefit an increased number of future periods, accountants capitalize rather than expense them.
  • Deferred maintenance is the practice of postponing maintenance activities such as repairs on both real property (i.e. infrastructure) and personal property (i.e. machinery) in order to save costs, meet budget funding levels, or realign available budget monies.

Key Terms

  • capital expenditure: Funds spent by a company to acquire or upgrade a long-term asset.
  • deferred maintenance: The failure to perform needed repairs could lead to asset deterioration and, ultimately, asset impairment.
  • depreciation: The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.
  • additions and improvement: expense accrued to increase the productivity of an asset

Valuing Repairs, Maintenance, and Additions

Betterments or improvements to existing plant assets are capital expenditures because they increase the quality of services obtained from the asset. Because these add to the service-rendering ability of assets, firms charge them to the asset accounts.

For example, installing an air conditioner in an automobile that did not previously have one is a betterment. The debit for such an expenditure is to the asset account, Automobiles.

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Car Repairs: Cars require regular maintenance. Such contingent liabilities can be estimated reliably based on historical cost and readily available information.

Occasionally, expenditures made on plant assets extend the quantity of services beyond the original estimate but do not improve the quality of the services. Since these expenditures benefit an increased number of future periods, accountants capitalize rather than expense them. However, since there is no visible, tangible addition to, or improvement in, the quality of services, they charge the expenditures to the accumulated depreciation account, thus reducing the credit balance in that account. Such expenditures cancel a part of the existing accumulated depreciation; firms often call them extraordinary repairs.

If an expenditure that should be expensed is capitalized, the effects are more significant. Assume now that USD 6,000 in repairs expense is incurred for a plant asset that originally cost USD 40,000 and had a useful life of four years and no estimated salvage value. This asset had been depreciated using the straight-line method for one year and had a book value of USD 30,000 (USD 40,000 cost—USD 10,000 first-year depreciation) at the beginning of 2010. The company capitalized the USD 6,000 that should have been charged to repairs expense in 2010. The charge for depreciation should have remained at USD 10,000 for each of the next three years. With the incorrect entry, however, depreciation increases.

Deferred maintenance is the practice of postponing maintenance activities such as repairs on both real property (i.e. infrastructure) and personal property (i.e. machinery) in order to save costs, meet budget-funding levels, or realign available budget monies. The failure to perform needed repairs could lead to asset deterioration and, ultimately, asset impairment. Generally, a policy of continued deferred maintenance may result in higher costs, asset failure, and in some cases, health and safety implications.

Valuing Asset-Related Costs

Under US GAAP (FAS 157), fair value is the amount at which an asset and its related costs could be bought or sold in a current market transaction between willing parties or transferred to an equivalent party other than in a liquidation sale. Therefore, asset repairs and maintenance are expensed on the income statement at the market value paid for the services rendered. Asset additions/improvements are capitalized to their respective asset accounts on the balance sheet at the market value of the addition.


Source: Accounting