A company’s value equals the difference between its combined assets and liabilities, so the cost approach has intuitive appeal. Although a cost approach analysis is laid out similar to a balance sheet, a document that most business owners are familiar with, it requires a substantial amount of work to convert a cost-basis balance sheet to the required standard of value.
Despite the extra effort, buyers and sellers are increasingly using this approach in mergers and acquisitions (M&As) to help break down the components of value, facilitate deal structure discussions and prepare for postsale purchase price allocations. Here are the basics of this valuation approach.
Retool the balance sheet
Valuation experts identify all of the subject company’s assets and liabilities under the cost approach, including those that aren’t recorded on the balance sheet. Next, based on the appropriate standard of value (typically, fair market value); they assign a value to each item.
There are many reasons why the book value of equity may not be a reasonable proxy of its fair market value. For example, under Generally Accepted Accounting Principles (GAAP), assets are recorded at historic cost. Over time, historic cost may understate market value for appreciable assets, such as marketable securities and real estate. In addition, some intangible assets — such as customer lists, brands and goodwill — are excluded from balance sheets prepared in accordance with GAAP, unless they were acquired from other companies. Balance sheets also might not include contingent liabilities, such as pending litigation or an IRS audit.
Additional valuation challenges are presented when companies use cash- or tax-basis accounting methods. A valuation analyst will usually convert the financial statements to an accrual basis. Their balance sheets may exclude accruals (such as accounts receivable and payable) and rely on accelerated depreciation methods that understate the market value of fixed assets. This process results in the creation of a market-based balance sheet. In order to revalue certain assets — such as machinery, equipment and real estate—separate appraisals may be required by outside specialists.
Understand the advantages
The perceived simplicity of the cost approach is often appreciated by the courts, especially when it’s used for asset holding companies and small manufacturers that rely heavily on their “hard” assets. It may also be useful when the parties present conflicting appraisal evidence.
The cost approach provides a useful “floor” for a company’s value, in some cases, when it serves as a sanity check for the other valuation approaches. After all, reasonable sellers typically won’t accept less than net asset value in M&A unless they’re under duress to sell.
In addition, because the cost approach in M&A assigns a specific value to the individual assets and liabilities that are owned by the business, many buyers and sellers turn to it. That’s different from either the income or market approach, which may indicate that a business is worth, say, 1.5 times annual revenues, but doesn’t assign value to assets and liabilities.
With a cost approach analysis, the buyer and seller can negotiate exactly which assets and liabilities to include (or exclude), allowing them to more effectively bridge gaps between the asking and offer prices. Then, after the deal is closed, a cost approach analysis can be used to allocate the company’s purchase price for tax and accounting purposes.
Weigh the pros and cons
Although the cost approach often requires significant time and effort to identify and revalue everything separately, it can provide valuable insight. In some cases, it’s easier and more cost-effective to apply the income or market approach — even though these methods may seem more complicated on the surface.