Valuation of a Business Based on its Assets (Invested Capital)
🔥 When selling or buying a company or part of it, is it possible to determine the value of the entity based on the capital it invested in its assets? Yes, but beware of following valuation
People sometimes use the value of the entity's historic investments and its Return on Invested Capital (ROIC) in the wrong way to determine the price.
Invested Capital | Assets
The Invested Capital of a company consists of assets. These assets consist of 2 groups: current assets
(cash, bank accounts, cash equivalents) and non-current assets
. Non-current assets in turn also consist of 2 main groups: fixed assets
(land, buildings, equipment, transportation vehicles, plant, machinery, furniture computers) and intangible assets
(brands, reputation, copyrights, patents, trademarks, trade secrets, know-how, goodwill). The total present value of all these assets minus all of the entity's liabilities can be said to be equal to the current value of the entity.
How should one determine the value of all these assets, in case an entire part of a firm is being sold or bought? Well, we are obviously interested in what the entity is worth at that moment; the "market value".
Current assets are typically valued at their (current) market value. Not too much worries here. But we should be careful with the non-current asset(s) of the entity. We should be asking ourselves:
- Are we using the book value of these non-current asset(s)—as is customary among financial managers in the accounting departments of many firms? Because there is no market value for these assets, the book value is typically based on what was historically invested in the non-current asset(s) minus charges for depreciation and amortization.
- Are we using the market value of these non-current asset(s)—as is customary among investors in stock markets?
Option A (book value) is fine in order to measure how well the entity is generating earnings from the capital it invested in its business. To the extent its ROIC is higher than its WACC it is earning money. But this value should never be considered to reflect the actual, current or future market value of the asset(s) of an entity (e.g., a machine, a factory, or even an entire business) if it is sold or acquired to determine the selling/purchasing price.
So, when selling or buying a company or part of it, one should use Option B (market value) as it accurately reflects and incorporates the expectations of the total value over time that will be created or destroyed by the purchase of selloff of the asset(s). This is the right one to use in case of such transaction.
The difference between A and B can be huge.
Source: Martin R.L. "What Managers Get Wrong About Capital", HBR May-Jun 2020, pp. 84-93.