The 7 basic principles of business valuation: Principle 4Jean-Claude Desnoyers
Principle N° 4 : The higher the underlying net tangible asset value of a business, the higher should be the going concern value of that business.
The fourth basic principle of business valuation tells us that the higher the company’s tangible net worth, the higher the operating value.
Let’s start by defining what the net tangible value of a business is in terms of operating value. It is the value determined using the tangible asset backing calculation. In the financial statements, assets and liabilities are separated between short-term assets (current) and liabilities (i.e. realizable / payable in the next year) and long-term assets and liabilities (realizable / payable in more than one year). Capital assets are usually referred to as part of long-term assets such as vehicles, buildings, equipment, etc. owned by the business. Short-term assets and liabilities are usually stated at market value, which is not the case for long-term assets and sometimes long-term liabilities. To determine the value of tangible asset backing, we will start with the equity and will adjust the value of the assets and debts to their fair market value. Assets and debts non related to the operations (ex. investments on the stock exchange) will be valued separately. The fair market value will be determined in this case, in going concern.
This principle tells us that the higher the value determined for the tangible asset backing, the greater the investment required to enter the industry and the lower the risk of new competitors entering the industry. Since the risk of a new competitor is lower, the rate of return required by the investor will be lower because the investment will be less risky.
The liquidation value of the operations is the value of assets and liabilities related to operations assuming that the activities of the business would cease and the assets and liabilities would be liquidated. The higher the liquidation value, the less the risk of losing in the event that the business does not succeed and less risky is therefore to invest. It should be noted that, as part of the business continuity valuation, this last principle has little or no bearing in the determining of the price in an acquisition.
Understanding the fourth principle of the business valuation
To illustrate this principle, I like to give an example for my clients.
Let’s say we compare two businesses in the same industry. The Green one has $ 1,000,000 equity, while the Yellow one has $ 500,000 in equity. Both businesses have the same profitability before interest of $ 1,000,000 per year.
In the event that both businesses should cease to operate and close their doors, which of the two would have a higher value?
Since the net value of the Green business is higher and has more equity, it is the one that will have a higher value on the market. All other things being equal, the business with the higher net asset value will have the highest operating value. The calculation of the net value is therefore decisive in the value that the business will have on the market and is not negligible.
The third basic principle of evaluation refers to the rate of return of a business as I explained in my last blog. The rate of return being a subjective factor in the valuation of a business, if the operating value and the liquidation value of a business are high, the risk will be less for the potential buyer.
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