Net asset valuation is an intuitively simple and easy way to value a company.
In the following we will provide a step-by-step guide to net asset valuation. The goal is that after reading this you should be well equipped to value a company (or your own net worth) through the use of net asset valuation.
Premise of net asset valuation
In net asset valuation, you basically ask the question: “If I sell everything this company owns, what is the amount of money I will get in my hands?”.
The steps to perform the valuation are the following:
- Determine the market value of your assets
- Subtract liabilities of the company
- Add cash to get equity value of a company
We will illustrate the valuation method through a number of examples throughout the text to make sure you understand what is going on.
When to use net asset valuation
Naturally, there are sectors for which it is much easier and more logical to use net asset valuation. For example, the revenue and profit a ship can generate is very linked to the cost of the asset. As such net asset valuation will be a good fit for the shipping sector.
On the other hand, there is an area such as software development. The development cost for Minecraft was very low, however, it was sold to Microsoft for $2.5 billion. If Minecraft had been sold for its development cost, it basically wouldn’t have been for a very high price.
As such, the more linked the profit generation of an asset is to its price, the better net asset valuation is. In the below figure, we have outlined how linked the profit generation of an asset is to the cost of the asset.
As such, the higher the profit link, the more accurate net asset valuation will be.
Step 1: Determine the market value of your assets
For starters, imagine not having a business but think of yourself. You (hopefully) own a variety of things and if you are short on cash you can sell these items to generate cash. This is basically what net asset valuation equates to, i.e. the market value of all its assets.
The principle is easy to understand, however, how do you figure out what the market value of all assets in a company is?
To understand this, let’s think of a company as an individual. We assume this individual owns a cheap chair, a brand new iPad and a two-year-old car. The chair was bought for $20, the iPad cost $400 and the car cost $10,000 (it was new). To get the market value of these, we value them one by one.
The chair is probably worthless. Chairs at that price are usually thrown out or given away. Outside of flea markets people will not even bother to spend a couple of dollars on it as they will have to drag it home. There is thus no functioning market for it and the chair is worth nothing.
The iPad on the other hand is brand new, still wrapped and you have the receipt. While you cannot recoup the $400 you spend on it, you post it on Craigslist and get an offer of $380. You thus only lose 5%
The car also has a functioning secondhand market, however, you have owned it for two years. A prospective buyer cannot know how you have treated the car and thus, it is harder for you to get a decent value for it. In the end, you end up selling it for $6,000 and a loss of 40% of your initial investment.
The market value of your assets is thus 0 + 380 + 6,000 = 6,380.
That’s fine but what does this have to do what valuing a company?
Well, in net asset valuation, you do exactly the same. Take the assets one-by-one, value them and sum it at the end. The hard part is valuing them, however, the value will be based on the same principles as above.
This means, that the better a secondhand market and the more equal information is the better a value you can get for a product.
Consider a large, cargo ship:
- Is there a secondhand market? Yes, cargo ships are traded every day
- Will information be equal? There are independent ship-brokers that verify the value of a ship at a relatively low price (compared to the price of a cargo ship)
Thus, it will be relatively easy to get close to full price for a ship.
Now consider a pharmaceutical R&D project:
- Is there a secondhand market? No, there are likely only a handful of large pharma companies that can buy (and value) this
- Will information be equal? In the best case, it will be very time consuming and expensive for a prospective buyer to get comfortable regarding the project
It will thus be very hard if not impossible to get a decent value for a R&D project.
The examples show, that there are simply assets that are more suited for net asset valuation than others. In general, “heavy, real” assets will be easier to value than intangible assets. In the table below, we have outlined what prices different types of assets usually commands:
Step 2: Subtract the liabilities of the company
The second step is relatively simple. You simple subtract the liabilities of the company.
Starting with an individual, the individual would likely not have loaned money for the chair or iPad, however, it is normal to loan money to acquire a car.
We will assume that there is an outstanding loan of $2,000 on the car. This will naturally have to be subtracted and we thus have $6,380 – $2,000 = $4,380 left.
This is the same in the company example. Unless a company is in distress, debt usually trade at par value (or close to it) and we simply take the value of liabilities on the books.
Step 3: Add cash to get equity value of the company
Before arriving at equity value we have one step left: Add the cash.
After paying off our car loan, we were left with $4,380. However, we also had $200 in our bank account and we are thus good for $4,580.
The same goes in arriving at the equity value of a company. We have to add the cash. Cash is always cash trading at par (you can always exchange $2 for another $2) and thus we simply add book value of cash to arrive at the equity value.