The idea behind the asset method is very straightforward: the value of a firm’s equity is the sum of the values of the firm’s assets less its liabilities; the whole is equal to the sum of its parts. Adding up the values of tangible assets and subtracting liabilities is not too complicated. The values of assets such as cash, receivables, and inventory are usually fairly close to the values found on a firm’s balance sheet. The values of assets such as real estate, equipment, and furniture cannot usually be simply picked off a balance sheet because they are likely to be recorded on the basis of historical acquisition prices. Current values of these assets are usually not reflected on balance sheets. However, separate appraisal of these assets is possible and usually not that difficult or expensive. The problem, and in fact the central problem of business appraisal, concerns the existence and measurement of the intangible asset goodwill.
Goodwill derives from customers’, clients’ or patients (CCP’s) willingness to repetitively patronize a firm. The Financial Accounting Standards Board (FASB) uses the term “customer relationships” and reserves the term goodwill for more global intangible assets. As I use the term, the value of that goodwill is a function of the additional revenue these repeat CCPs provide. Generally Accepted Accounting Principles (GAAP) do not provide a mechanism for smaller closely held firms to measure or reflect goodwill on their balance sheet. So you will not find goodwill as a line item on a firm’s balance sheet. And yet we know that in many cases goodwill is very clearly present. How do we know? Because buyers of smaller closely held firms frequently pay significantly more than the cumulative value of the net tangible assets of those firms.
The challenge then for appraisers is to determine if goodwill exists, and if it does to determine its value and add it to the value of the firm’s net tangible assets to arrive at the total value of the firm. It turns out there is a very old method developed to do just that variously called the treasury method or excess earnings method. Here is a description of this approach.
This method is based on the idea that the presence of goodwill can be detected and measured by the existence of profits in excess of some “average” rate of return on a firm’s tangible assets. The method involves three steps. First, we compute a “fair” rate of return on tangible assets. Second, this return on tangible assets is subtracted from the total net income historically realized by the firm to arrive at an excess earnings figure. Finally, we convert this excess earnings figure into a lump sum by dividing by an appropriate rate (this rate is called a capitalization rate).
Example. Suppose a firm has $45,000 of tangible assets, $10,000 of liabilities and $50,000 net income. Assume that a fair return on tangible assets is 10% and an appropriate capitalization rate is 20% (a capitalization rate is a rate that is divided into net income to yield the value of the firm’s goodwill). The excess earning approach would compute a value of $227,500 to the goodwill and an overall equity value of $262,500 based on these computations.
There is a major theoretical and a practical problem with this method. From a practical standpoint there is no obvious way to separate the overall net income of a company into two components because there are no databases showing historical rates of return derived strictly from tangible assets and there are certainly no databases showing historical rates of return derived strictly from goodwill. Usually net income from any business derives from a synergistic use of all operating assets, tangible and intangible.
There are no theoretical grounds for assuming that the tangible assets provide a base level of return and that any excess above this base level is attributable to goodwill. Why not assume the reverse order? In the service businesses, it is usually the skill and experience of the owner management and staff that drive returns rather than the tangible assets. In many of these businesses there is only a small amount of tangible assets precisely because such assets are not as essential to the earning process.
Replacement cost is an alternative asset method used to appraise goodwill. Equipment and machinery is often appraised on the basis of replacement cost. The theory behind this holds that the value of a piece of equipment or machinery cannot be worth more than the cost to replace it. This replacement cost concept has been applied to the appraisal of goodwill. Here is an illustration of this technique:
Example: Assume that a firm has 200 customers whose value we seek to appraise. Assume that the firm has an annual marketing budget of $10,000 and that on average the firm’s marketing efforts lead to 10 new customers per year. Thus, the cost per new customer is $1,000. So, a reasonable estimate of the cost to replace a 200 customer base would be $200,000 (200 x the average marketing cost per new customer) and this would be an upper bound value for the goodwill of the firm.
This is certainly a simple and logical appraisal approach but there are at least three major practical problems. First, in the service sectors, marketing costs are vanishingly small because direct marketing is less than cost-effective for gaining any significant amount of new customers, clients or patients (CCPs). Second, in very competitive markets, the average cost of gaining a small number of new CCPs is likely to be far less than the cost of gaining a large number of CCPs. In fact, the unit cost of gaining new CCPs is likely to rise significantly as the number of new customers sought increases. Finally, the cost of acquiring new CCPs does not necessarily reflect their value. The value of a CCP base ought to reflect the future economic benefits that CCP base will generate and the cost approach utterly ignores this factor. For these reasons, another more reasonable asset approach has been developed.
The customer attrition approach explicitly recognizes that the value of a CCP base resides in the future profits it will generate. This approach also has the added benefit of recognizing that an acquired CCP base has a finite life. CCPs are lost due to relocation, death, or competition. In order to apply this method, the income stream from the CCP base and the rate of CCP loss must be taken into account. Here is a very simplistic illustration of the approach:
Example: Suppose we have a firm with a CCP base of 100 customers that for the sake of simplicity we expect to generate precisely $500 in net income per year, per customer. Suppose we expect after the firm is acquired precisely 20 customers per year will be lost over the next five years. As with the excess earnings method, it is further assumed that some of the net income represents a return on tangible assets and the balance represents a return on the CCP base (see the excess earnings method discussed above). It is assumed that three quarters of the net income is a return on tangible assets and only the remainder represents a return on the customer base itself. Finally, a present value factor of 10% is assumed . Here is the computation of the value of the CCP base.
The present value of the goodwill would be added to the value of the tangible assets less the liabilities of the firm to arrive at the value of the firm’s equity.
This method is far superior to the methods previously described in that it recognizes that the value of the CCP base is directly a function of future net income and that the net income will decline over time. The method goes off the rails when it attempts to convert the future net income stream to a lump sum using an excess earnings model. As previously noted, there is simply no theoretical or empirical way to support an allocation of net income between tangible and intangible assets.
Many business appraisers and even the IRS has recognized the problems with the excess earnings approach. See this brief but accurate opinion.
Copyright 2018 Michael Sack Elmaleh