Many Case Study requirements ask what a business, or a share in it, is worth. A buyer wants a maximum price, a seller wants a minimum and a client wants advice. There is no single right value, only a reasoned range. This topic covers why valuations are done, the three broad approaches, and the asset-based methods with worked examples.
In 30 seconds
Valuation is needed for takeover bids, flotations, private sales, mergers and tax on estates. All methods rest on estimates and give different answers, so use several, compare them and recommend a price range with reasons. The three approaches are asset based, market based (earnings or dividends) and cash-flow based. Asset-based values come in three forms: net asset value from the books, realisable (break-up) value and replacement value.
They usually understate a going concern because they leave out goodwill and other intangibles. The calculation is only part of the answer: give the context, your reservations and a clear recommendation.
Why a business is valued
A valuation may cover a business, part of a business or a proposed investment. The Case Study may ask for a price earnings valuation, a net present value or a similar method.
The marks go to professional skill, so the calculation must be accompanied by three things: the context (why this technique and these bases), judgement (what reservations apply and should be disclosed) and conclusions or recommendations (what the results mean and what the client should do).
The method depends on the purpose and on whether the company is quoted or unquoted.
| Company | Reason for valuation |
|---|---|
| Quoted | Value is normally the market price. A valuation is mainly needed for a takeover bid, where the bidder offers more than the market price. The aim is a fair or maximum price that will attract the target’s shareholders |
| Unquoted | A flotation, where an issue price must be set. A private sale, where the buyer needs a maximum price and the seller a minimum. A merger, where terms depend on relative values. The tax liability on the estate of a deceased shareholder |
The three approaches
All valuation methods are based on estimates and assumptions. Each gives a different price, and each gives useful information about what to offer. You should be able to calculate each method, discuss its assumptions and compare the results, then recommend with reasons a value that suits as the basis for an offer to the target’s shareholders. In practice the final price is always agreed by negotiation.
| Approach | Basis |
|---|---|
| Asset based | The value of the target’s assets less its liabilities |
| Market based | Estimates of future earnings or dividends, such as the price earnings (P/E) and dividend methods |
| Cash-flow based | Discounted cash flows of expected future returns, including the economic value added (EVA) model |
Asset-based methods
There are three variants.
Net asset value. This uses the book values in the statement of financial position: net tangible assets, with assets and liabilities at their book values. Non-current assets are usually at cost less depreciation, though that may reflect current value where assets are revalued regularly. Important intangibles, such as internally generated goodwill and human capital, do not appear. So at best this method gives a minimum value of the business.
The reasoning matters in the exam: shareholders are unlikely to accept an offer below net asset value per share, so the offer will normally need to be higher. If a value from earnings, dividends or cash flows is lower than the asset value, the bidder should be concerned.
Net realisable value. This is the break-up value: what the assets would fetch if sold in a liquidation, less the liabilities. It is usually irrelevant to a buyer of a going concern, because the value of assets in a going concern is normally higher than their break-up value. It acts as a floor, since a company is in principle never worth less than its break-up value.
Net replacement value. This is the cost of acquiring the net assets on the open market, less depreciation. It is often more accurate than book value, but it still ignores intangible assets and so can undervalue the business.
All three share one criticism. A business is acquired to use its assets to generate returns, not to sell them. Its value is better judged by the returns it will generate than by the value of its assets.
Worked example
Scenario (fictitious figures, ₦ million). Bimbus Nigeria Ltd has 100 million ordinary shares. Its book values are tangible non-current assets 500, intangible assets 150 and current assets 120. Liabilities are bank loans of 180 and current liabilities of 40. The non-current assets could be sold for 600 now, or replaced on the open market, less depreciation, for 750. Value the shares on each asset basis.
- Liabilities.
180 + 40 = 220. - Net asset value.
Book net assets = 500 + 150 + 120 − 220 = 550, so ₦5.50 a share. - Net realisable value. Disposal value 600 plus current assets 120 less liabilities 220 = 500, so ₦5.00 a share. Intangibles are given no value in a sale.
- Net replacement value. Replacement cost 750 plus current assets 120 less liabilities 220 = 650, so ₦6.50 a share.
- Judgement. The range is ₦5.00 to ₦6.50. None of the three values the earning power or the ₦150 million of intangibles, so a bidder should expect to offer more than ₦5.50 for a profitable company and should check the figures against an earnings-based value.
A smaller case shows the same steps. Datcom Nigeria Ltd has assets valued at ₦25 million on a disposal basis and liabilities of ₦7 million. It has 2,000,000 shares. Net realisable value is 18 million ÷ 2,000,000 = ₦9 a share.
Common mistakes
- Presenting one value as the answer instead of a range with reasons.
- Using book net assets as if they included goodwill and other intangibles.
- Forgetting to deduct all liabilities, including long-term loans.
- Using break-up value as the price for a going concern.
- Calculating without saying why the method suits the purpose, or what the reservations are.
Quick revision
- Quoted: market price, takeover premium. Unquoted: flotation, private sale, merger, estate tax.
- Three approaches: asset based, market based, cash-flow based.
- Asset values: book, realisable (floor), replacement. All ignore intangibles.
- Compare methods, recommend a range and disclose reservations.
- The final price is agreed by negotiation.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria exam. Try each one before you open the answer.
Question 1. Net assets are ₦275,000 and there are 50,000 shares. Net asset value per share is:
- ₦3.50
- ₦5.00
- ₦5.50
- ₦6.00
Show the answer
C. 275,000 ÷ 50,000 = ₦5.50.
Question 2. Break-up value is best described as:
- The cost of replacing the assets
- The amount realised if the assets are sold in a liquidation, less liabilities
- The book value of the shares
- The discounted value of future dividends
Show the answer
B. It is a floor and is usually irrelevant to a buyer of a going concern.
Question 3. Why do asset-based methods usually undervalue a profitable business?
- They include too many liabilities
- They leave out goodwill and other intangibles
- They use market prices
- They discount cash flows
Show the answer
B. Internally generated goodwill and human capital are not in the statement of financial position.
Question 4. In a takeover of a quoted company, the bidder usually offers:
- Less than the market price
- The market price exactly
- More than the market price
- The net asset value
Show the answer
C. The offer must attract the target’s shareholders.
Question 5 (8 marks). Explain the three asset-based valuation methods and one weakness they share.
Model answer
Show the model answer to Question 5
Methods (6 marks). Net asset value uses the book values of assets and liabilities in the statement of financial position, so it gives a minimum value that omits intangibles. (2) Net realisable value, or break-up value, is what the assets would realise in a liquidation less liabilities, and it is a floor that is rarely relevant to a going concern.
(2) Net replacement value is the cost of acquiring the net assets on the open market less depreciation, which is often more accurate than book value. (2)
Shared weakness (2 marks). All three ignore the earning power and intangible assets such as goodwill, because a business is bought for the returns its assets generate, not for their sale value.
The next topic covers valuing shares by price earnings, earnings yield, dividend yield and dividend growth models.
Pathfinder on Business valuation: purpose, approaches and asset-based methods
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
The client asked for a fair value and advice on the price to pay, though the market price was thought unreliable. Compare the asset-based range with the dividend value in the next topic.
Revise first: The three approaches
The requirement asks for a range of prices based on agreed share valuation models. Use the comparison and negotiation points in this topic.
Revise first: Asset-based methods
Source: ICAN Pathfinder, Case Study. Diets covered: November 2014 and November 2017.
Spotted a mistake? Tell us and we will check it.
