There are two main categories of company valuation methods. There is the substance value approach, which is based on the company’s assets, and the future earnings approach, which is based on the expected future earnings of the shareholders. Profitable businesses often have assets that are worth more than their book value. A company’s substance value can be viewed as its minimum value. So what pros and cons does the substance valuation method bring to the table?
Essentially, it is the amount of cash that would be returned to the owners of the company if it had shut down, settled its debts, and liquidated all its assets. The substance valuation method is also known as the asset-based valuation approach. The book value (BV) method is the most common substance-based valuation method. The book value of equity is equal to the balance sheet value of a company’s assets less its liabilities. To put it another way, this is what shareholders would get if the company ceased to operate, sold its assets, and paid its debts.
However, this method is most appropriate in situations where there are no significant intangible assets, or when a company is voluntarily liquidating its assets as a result of ceased operations.
Pros and Cons of Substance Valuation Method
If a company is having liquidation issues, it will typically use the appropriate asset or substance valuation method. Asset-based valuation is also used by firms in the investment niche, like financial or real estate investments, where assets are determined by income or market approach.
However, asset-based valuation is not without its shortcomings. When compared to other methods, such as the income approach, the asset-based method ignores a company’s future earnings. As a result, a company’s business value can be much higher than when its existing assets are sold off one by one.
In addition, the process of calculating intangible resources can be quite complex since internally generated goods do not appear on the balance sheet. The science of value is only a fragment of the equation when determining the value of a company. It takes a great deal of experience, accuracy, and proper attention to detail when valuing assets. In general, business owners are discouraged from undertaking individual business valuations due to the complexity of the process.
In some cases, asset-based methodologies can be complex since few companies have the objectivity and accuracy to determine what their assets are really worth. This can affect the accuracy of the final valuation as well as the true determination of the company’s worth.
When it comes to valuing a business, there are a variety of methods available to use, but the substance valuation method is often preferred because it is applicable in situations where a business is struggling with liquidity issues. Core niches like the real estate industry benefit greatly from the substance valuation method. However, it is important to note that it also has its own limitations. Some of the drawbacks of the substance valuation method include being quite complex to implement, especially for companies that have little experience.