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Role Of Assets In Determining Business Value

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The role of assets in determining the value of a business is not as intuitive or simple as many business owners might think. I think most business owners would agree that they do not own a business for the purpose of owning assets but instead own business assets for the very specific purpose of generating an income stream. This article highlights that the nature and quality of a company’s assets are very important factors in the overall consideration of business value and day-to-day operations, but ultimately it is the income stream generated by a business that most directly determine business value.

 

Naturally, businesses with tangible assets such as equipment and inventory have advantages such as the ability to obtain financing based on asset collateral and generally provide buyers with a higher degree of confidence relative to investing money in companies with tangible assets. However, capital intensive companies also have the disadvantage of generally having higher overhead and capital expenditures compared to less capital intensive businesses.

 

Without going too deep into business valuation theory and practice, there are three fundamental approaches to determining the value of a business. These three approaches are: 1) Asset Approach; 2) Market Approach and 3) Income Approach. The asset approach is generally considered to materially underestimate the value of a company that is a profitable, going concern and therefore primarily applicable to distressed or marginally profitable companies. Alternatively, the value of the vast majority of businesses that are a “going-concern” and profitable is determined by the market and/or income approaches. It is interesting to note that both the market and income approaches rely directly on a company’s income stream to determine business value. The income stream is multiplied by a market-based multiple in the case of a market approach value while a discount rate is applied to forecasted, future income streams in the case of an income approach value. Therefore, in profitable businesses, the income stream directly determines business value whereas the underlying assets have a less direct influence on the value of a business. 

 

There have been numerous times when after I have prepared and presented a business valuation, the owner asks “What about the value of my equipment and inventory?” I usually respond that the value of tangible assets is a very important factor and consideration but that the income generated by the business will most directly influence the value of the business. This is not to say that assets aren’t very important because they are to the extent management is able to generate an income from them. I illustrate this point by describing two entirely comparable manufacturing businesses that each have $1 million in equipment and inventory value but one company generates an annual income of $1 million while the other has annual income of $500,000. Clearly, even though they have identical asset value, the business with the higher earnings is of far greater value to the owner and prospective buyers.

 

The nature and quality of underlying tangible assets are a factor taken into consideration in determining the market-based multiple or discount rate for business valuation purposes but have less direct influence on business value than the income stream and is one of many factors that ultimately determine the conclusion of value.  This is not to say that equipment, inventory or other tangible assets are not critical because nothing could be further from the truth. Rather, it is important to understand that at the end of the day, it is how assets and company resources are deployed to generate income that matters most when determining business value. This is the reason that businesses can sell at values far exceeding the market value of the underlying business assets.