The prior post discussed the discounted cash flow (“DCF”) method of valuation. A business also may be valued based on the net value of its assets. This is sometimes called the “book value” or “net asset value” of a business, and it is calculated by looking at the balance sheet of the business and subtracting liabilities from assets.
The main benefit of the asset value approach is that it is simple in comparison to other approaches, especially DCF. However, there are several weaknesses. An asset’s book value may not reflect current economic value because it may: (a) rely on outdated historical acquisition costs; or (b) have been adjusted in the past for depreciation. Moreover, the asset value approach also is criticized for providing a static value — i.e., a value at one point in time — without sufficient consideration for the business’s value as a “going concern.” In this regard, book value is similar to the “liquidation value concept” in accounting, in which assets are individually valued in anticipation of a liquidation of the business.
Further, the book value of a business may be dramatically different depending on accounting treatment, rather than economics. Notably, a business that uses the cash basis accounting method assigns no asset value at all to its accounts receivable, whereas a business using the accrual method of accounting considers accounts receivable a valuable asset, typically once the services are rendered or goods are shipped. Thus, book value may undervalue, for example, a law firm that uses cash basis accounting because the firm’s accounts receivables are not reflected as assets on its balance sheets.
“[T]he potential for inaccurate [asset] valuations and the fact that accounting practices do not always mirror future economic realities lead financial theorists to give less credence to this valuation method.” Stockton, 2001 Colum. Bus. L. Rev. at 186. Nevertheless, book value is an approach that has been accepted by Illinois courts. E.g., Inst’l Equip. & Interiors, Inc. v. Hughes, 204 Ill. App. 3d 922, 150 Ill. Dec. 132 (2d Dist. 1990).
Moreover, “goodwill” is an intangible asset on a company’s balance sheet. “In the purchase of a business, goodwill generally is the difference between the purchase price and the volume of the assets acquired.” Black’s Law Dictionary (Sixth Ed. 1990). Because the value of goodwill is highly subjective, there is always a risk that a company overvalues its goodwill in an acquisition. Therefore, in disputes concerning book value, the value assigned to goodwill is often scrutinized.
(This is for informational purposes and is not legal advice.)