Asset-Based Approach (Cost Approach)

The principle underlying the asset-based approach is that the value of ownership of an enterprise is equivalent to the fair value of its assets less the fair value of its liabilities.

The asset-based approach, also known as the cost approach, is rarely used for the valuation of going concerns due to the difficulties in valuing certain tangible assets. There is more readily available information to value operating companies as an integrated whole rather than on an asset-by-asset basis.

Companies that the asset-based approach would be appropriate include:

• Operating companies without prospects of doing better in the future assuming the winding of operations.
• Resource and financial companies whose portfolios can be priced based on market variables.
• Holding investment companies like REITs.
• Very small businesses with limited intangible value or early-stage companies.

Question

Which of the following companies is least likely to be valued using the asset-based approach?

1. Large mature companies are expected to continue operating.
2. Small companies with uncertain futures.
3. Resource and financial companies.

Solution

The correct answer is A. 

The asset-based approach would not be appropriate for large mature companies expected to continue operating into the future. This is because the company expects to earn returns in the future that would not be considered using the asset-based approach.

B is incorrect. Small companies with uncertain futures would most appropriately be valued using an asset-based approach as it is difficult to forecast their cash flows.

C is incorrect. Resource and financial companies can be valued using the asset-based approach as their portfolios can be priced based on market variables.

Reading 27: Private Company Valuation

LOS 27 (i) Describe the asset-based approach to private company valuation.