Background :
There are many methods of valuation of shares or businesses. One of the commonly used approaches of valuation is Net Assets Approach. Before we look into the finer aspects of this method, it may be important to note that each method of valuation proceeds on different fundamental assumptions. The data which is used for valuation has to be carefully chosen. In current times, when you have lots of data available at a click of the mouse, one needs to obtain and analyse only the relevant data. It is observed that lots of time is wasted in reviewing irrelevant information and at the end, time at disposal to review the relevant data is limited. One more factor which has materially changed in last couple of years is the time available to complete the valuation. There are times when the urgency is self-created or artificial. Only in few cases the urgency is justified.
Let us now look at some finer aspects of Net Assets Method.
1. The Net Assets Method represents the value of a share with reference to the historical cost of the assets owned by the company and the attached liabilities on the valuation date. Such value represents the support value of a share of a going concern. It is usual to ignore the market value of the operating assets under this method.
2. While the historical cost is adopted in respect of the assets that are to continue as a part of the going concern, it is necessary to adjust the market value of non-operating assets such as investments and any assets which are capable of being easily disposed of, without affecting the operations of the company.
3. The value as per Net Assets Method can also be arrived at by considering the replacement cost or the realisable value of the assets owned by the entity. This value generally represents the amount, which the company can fetch, if the assets are sold.
4. Under what situations Net Assets Method is adopted ?
The method to be adopted for a particular valuation must be judiciously chosen. Net Assets Method may be adopted in the following cases :
- In case of start-up companies, where the commercial production has not yet started.
- In case of manufacturing companies, where fixed assets have greater relevance for earning revenues. It would also be appropriate to use Net Assets Method for valuation in case of companies operating in the industry, which is capital intensive and is relevant to revenues in an industry, where norms are related to the capital cost per unit.
- In case of companies where there is no reliable evidence of future profits due to significant fluctuations in the business or disruption of business.
- In case of companies, where there is an intention to liquidate it and to realise the assets and distribute the net proceeds.
5. Methodology :
The value as per Net Assets Method is arrived at as follows :
- Net Assets value represents equity value which is arrived at after reducing all external liabilities and preference shareholders’ claims, if any, from the aggregate value of all assets, as valued and stated in the balance sheet as on valuation date. It is very important that the valuer critically goes through the financial statements (Directors Report, Management Analysis and Discussions, Auditors Report, Accounts including notes). It is experienced that on review of all the above documents, chances of missing any important adjustments are very less.
- The value so arrived at is further adjusted for contingent liabilities, if any, as on valuation date and increase in realisable value of surplus assets and investments on a net of tax basis to arrive at the value as per Net Assets Method.
6. Some issues and its treatment in valuation :
The following are some issues which one has to deal with in arriving at the Net Assets Valuation :
6.1 Contingent liabilities :
The amount of contingent liabilities as disclosed in the financial statements of the entity or otherwise needs to be given due consideration. The management’s perception of such liability materialising may also be considered. It is observed that certain items of contingent liabilities may involve a very peculiar technical or legal issue. It is not uncommon in such situations to seek some expert’s view in the matter. The valuer should mention in his report the adjustments made based on opinion of the expert. When an impact of contingent liabilities is captured in the valuation, if the item is tax deductible, the amount should be considered after taking into account the tax impact. For example if contingent liability on account of excise duty liability is, say, Rs.100. If the valuer has taken probability of 50% for such liability, the amount to be reduced from Net Assets of the company should be Rs.33 [Rs.100 X 50% X (100% — 33.99%)]. If the claim is in arbitration and the award is likely to take a long time, it is usual to take present value of such liability.
6.2 Investments :
If the entity which is being valued is holding shares in other companies, the same needs to be valued and captured in the overall valuation. Investment in shares and securities, which are regularly traded in a stock exchange, may be valued on the basis of the prices quoted on the stock exchange. It is usual to take either 3 months or 6 months average if the holding is large. For small lots a single day market price may be used. It must, however, be seen that there is regular trading in those securities. An isolated transaction may lead to erroneous results.
In case of quoted shares with isolated transactions and also in case of unquoted shares, if the amount is material, a secondary valuation of such shares may be necessary using accepted methodology of valuation.
In case of investment in subsidiary company, net asset value of the subsidiary may be considered instead of the cost.
The appreciation or diminution in the value of any investment needs to be taken after taking into account notional tax implications, as applicable.
6.3 Surplus assets :
There are many entities which are holding certain assets which are surplus in nature. They are not used for any operations of the entity. It could be a vacant flat, vacant land or a closed factory. It is generally observed that if such assets are disposed off, it will not affect the operations of the entity. The identification of surplus assets is an important task. Generally the valuer accepts management’s representation on the same. However it is always better to review the facts based on which a particular asset has been identified as surplus. In many cases it is observed that the assets identified as surplus were not surplus in nature. For example area vacant between two factory buildings was identified as surplus in one case. However it was not actually possible to dispose of that piece of land as it would have materially affected the operation of the plant. In such case it is not surplus asset.
It is usual to take the market value of the surplus assets based on a report of the technical valuer. The appreciation or depreciation in the value of surplus assets adjusted for the tax liability on such appreciation or depreciation would be added/deducted from the Net Assets Value.
6.4 Fixed assets :
While valuing the Shares/Business of a Company, the valuer takes into consideration the last audited financial statements and works out the net asset value. Following factors needs consideration in respect of fixed assets :
- It has to be seen that book value is arrived at after charging adequate depreciation consistently. Any capital improvements in the past, which have been charged-off to revenue, should also be taken into account.
- In taking the value of plant and machinery, the factor of obsolescence due to technological improvements, changes in designs, etc., should be given due consideration. If due to technical improvements, the present machinery is found to be so outdated that it has to be discarded, then the value which the plant and machinery would fetch, if sold piece-meal, should alone be taken account of.
- At times, when a transaction is in the nature of transfer of asset from one entity to another, or when the intrinsic value of the assets is easily available, or when the projections of future profits cannot be made with reasonable accuracy or where there are losses or where the value of the entity is derived substantially from the value of its assets, the valuer can consider the intrinsic value of the underlying assets. For determining the intrinsic value of fixed assets, the valuers can place reliance on report from the approved Chartered Engineers or other approved valuers.
6.5 Inventory and debtors :
Due allowance should be made for any obsolete, unusable or unmarketable stocks held by the company. In case of debtors, bad debts and debts, which are doubtful of recovery need to be adjusted. If the valuation is carried after the Due Diligence Review, all adjustments arising on account of such review need to be captured in the valuation.
6.7 Contingent assets :
If the company has made escalation claims, insurance claims or other similar claims, then the possibility of their recovery should be carefully made, particularly having regard to the time frame in which they are likely to be recovered. The present value of such claims can be added to the valuation.
6.8 Qualifications & Notes to Accounts :
Qualifications in the Auditors Report and Notes to Accounts should also be given due consideration. If it calls for any adjustment, the same should be carried out while arriving at the Net Assets Value. Such items could be diminution in the value of long term investments not provided for, provision for gratuity and leave encashment not made, provision for doubtful debts not made, etc.
6.9 Liquidation :
Where the business of the company is being liquidated, its assets have to be valued as if they were individually sold and not on a going concern basis. In such cases, the total net realisable value will often be less than that on the basis of a going concern.
Regard should also be had to the tax consequences of liquidation. If fixed assets are to be sold at a price in excess of cost, the capital gains tax should be taken into account.
6.10 Brought forward losses :
Brought forward tax losses of a business should be considered if the buyer of the business would be entitled to take benefit of set off of such losses. Generally there is a practice to share the benefit of tax losses between both the parties.
6.11 Warrants :
If the Company has issued warrants which are yet to be exercised, the valuer has to take a call considering the current fair value and the amount to be paid on warrant conversion. If the fair value is higher, the warrant holder is likely to exercise his right. In such cases, amount receivable on warrant is added to the Net Assets Value. To arrive at the per share value, the current number of shares as well as the additional shares on exercise of warrants is considered.
Conclusion :
In many cases, Net Assets Method may not be relevant particularly where human capital or intangible are main assets used for generating revenues. In such cases, the Maintainable Profit Basis or the Discounted Cash Flow Method may be adopted.
For companies using tangible assets such as plant and machinery, building, etc, this method is relevant. Net Assets Method may sometimes be used as a backup to support the value arrived at as per other methods. In many cases, particularly valuation for mergers, Net Assets Method is used alongwith other methods but is given a lower weightage in arriving at final fair value. In many court cases where valuations were challenged, usage of Net Assets value as one of the methods of valuation was well accepted.
Following is an illustration of Valuation of Company PQR Ltd. as per the Net Assets Method :
