Deloitte | A Middle East Point of View - Spring 2017 | -based approach

Reading between the lines The merits of an asset-based approach to valuing businesses

36 Deloitte | A Middle East Point of View - Spring 2017 | Asset-based approach

37 Deloitte | A Middle East Point of View - Spring 2017 | Asset-based approach

angible form the core of Illustrative example Company A Net book Adjusted many companies’ balance sheets. (US$’ 000) value NAV T These include real property (such Tangible assets 12,500 20,000 as land, building, improvements) and Intangibles (software) 500 500 personal property (including machinery, Intangibles (customer relationship) 1,000 1,000 2,500 equipment, motor vehicles, furniture, Other assets 1,000 1,000 computer equipment, etc.) Total assets 17,500 Bank debt (loan for assets) 7,000 7,000 The 2008 financial crisis and the recent Other liabilities 3,000 3,000 Net of 7,500 economic sentiment from the relatively Adjusted net asset value 12,500 low oil price has reminded of Going concern value (income-based) 17,500 17,500 the instability of earnings and the Implied price/book multiple 2.3 1.4 associated unpredictability of the future performance of businesses. This When valuing income-generating under a liquidation scenario. In increased risk from cash-flow uncertainty businesses, the usefulness of this determining the value using this is encouraging equity and debt investors approach may be limited as it does not approach, the intangible assets that to understand the worth of a business capture the future income-generating cannot be sold separately from the based on the value of its underlying potential of the business or the value of business are excluded and the value is tangible assets. its goodwill and other intangible assets. adjusted for estimated costs of disposal; It does, however, present a reality check implying a value of US$9m to Company A. The asset-based approach to the overall business valuation in is less complex and easier to apply providing an estimate of the potential In instances where the business is a The asset-based approach to valuation lower end of the valuation range of the going concern, an assessment of the focuses on a company's net asset value business. liquidation value acts as a useful (NAV), or the fair market value of its total measurement aid of the downside risk assets minus its total liabilities, to The asset-based valuation provides for an by providing an determine what it would cost to recreate an indication of the downside risk approximation of the net realizable value the business. While there is some room In order to correctly apply the asset- in the event the business is wound up for interpretation in terms of deciding based valuation approach, a fundamental shortly after . which of the company's assets and decision needs to be made upfront as to liabilities to include in the valuation, whether the net tangible assets of the A value of the underlying tangible an asset-based valuation approach is business comprise part of a going assets impacts the overall business generally the easiest to apply relative to concern entity or, alternatively, they do value the traditional income-based and market not and must be liquidated. A potential debt or equity investor will approaches. take into consideration the value of the Taking our example further, if say, due underlying tangible asset when deciding As an illustrative example, if we consider to certain new industry regulations, the on the appropriate pricing for equity or Company A, a pipe manufacturing prospective viability of Company A as a a loan rate for providing debt to a business that has been operating for going concern is uncertain, it would be businesses with limited historical 10 years and has a net book value of appropriate to understand its value information. US$7.5m, its tangible assets are estimated to have a fair market value in Illustrative example Company A Adjusted NAV excess of their book value if applying the (US$’ 000) Net book Value in use Liquidation value value adjusted net asset approach. One of the reasons for this is that some equipment Tangible assets 12,500 20,000 17,500 Intangibles (software) 500 500 500 that was fully depreciated for accounting Intangibles (customer relationship) 1,000 1,000 purposes is expected to have an Goodwill 2,500 economic useful life for years to come. In Other assets 1,000 1,000 1,000 applying the adjustments, the value of Total assets 17,500 Bank debt (loan for assets) 7,000 7,000 7,000 the equity of Company A becomes Other liabilities 3,000 3,000 3,000 US$12.5m. Net book value of equity 7,500 Adjusted net asset value 12,500 9,000

38 Deloitte | A Middle East Point of View - Spring 2017 | Asset-based approach

A business with a greater portion of Company A Company B tangible assets on its balance sheets is (US$’ 000) Net book Liquidation Net book Liquidation considered safer for an equity investor as value value value value it may mitigate the loss potential. The Tangible assets 12,500 17,500 12,500 13,500 higher the value of the tangible assets, Intangibles (software) 500 500 500 500 the lower the potential risk and the Intangibles (customer relationship) 1,000 1,000 higher the potential business value, and Goodwill 2,500 1,500 Other assets 1,000 1,000 1,000 1,000 vice versa. Total assets 17,500 16,500 Bank debt (loan for assets) 7,000 7,000 6,000 6,000 The asset lever for an equity investor Other liabilities 3,000 3,000 3,000 3,000 Net book value of equity 7,500 7,500 Adjusted net asset value 9,000 6,000 Tangible Asset Backing (TAB) 2,500 7,500 3,500 4,500 Loan to net assets % 78% 100%

Value/price Assets Risk It is important to note that while making It is important to note The asset lever for a debt investor an assessment of the underlying tangible asset backing and the liquidity value is a that while making an useful tool when deciding on the value assessment of the of a business, these do not necessarily represent the true value of a going underlying tangible asset concern. The asset-based valuation Assets Risk Loan rate backing and the liquidity methods are more suited to valuation value is a useful tool of going concern operations of asset- Debt investors often seek assets pledged intensive businesses with little value when deciding on the to them by the borrower as collateral. from goodwill or intangibles, not-for- value of a business, these These are viewed by the debt investor as profit organizations or businesses to be a secondary source of loan repayment purchased from a competitor in a similar do not necessarily should the borrower be unable to repay industry. represent the true value the full amount. As such, all things being equal, the higher the value of the Concluding remarks of a going concern collateralized assets, the less risky the The need to know the worth of a borrower, and the lower loan rates business is one of the most common In emerging economies there generally obtainable. questions that transacting parties look is a high level of information asymmetry to address upfront. Whi le different and the investor has a significant An asset-based valuation may not valuation methods may be considered information disadvantage due to opaque always represent the true value of in undertaking a potential valuation, the financial statements or undisclosed a going concern choice of the appropriate methodology is information. This has led debt and equity Back to our illustrative example, dependent on the characteristics of the investors to look more closely at their Company A and Company B are identical subject asset being valued, the purpose downside risk, and seek asset-based in all material aspects and have the same of the valuation and the availability of valuations as a supplemental, if not an net book values. However, Company B reliable data. alternate approach, to the traditional has a significantly lower liquidation value income and market-based valuations. as its tangible assets are not as valuable While an asset-based valuation approach Considering the challenging market in the used equipment market. provides a comprehensive analysis of the sentiments and the tightening liquidity Considering its higher tangible asset asset of a business, its benefits conditions, the relevance and demand backing, Company A will be perceived as vary across industries. Medical device for asset-based valuations is expected a less risky investment to a potential manufacturers, for example, have high to increase across the region. equity investor or a debt provider. While levels of valuable intangible assets that US$9m may indicate a downside value may be difficult to value. In valuing a by Munish Mohendroo, Partner, for Company A given the operating risk going concern the assessment of the Valuations, Financial Advisory, Deloitte, from the new industry regulations, it is asset-based liquidation value provides Middle East not necessarily representative of the an investor the potential downside value actual value of Company A under a of the business. It may, however, not going concern scenario. necessarily represent the true value of a company.

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