Adjusted Book Value Approach

The adjusted book value approach represents the value of a business as a going concern when there is no expectation of any type of commercially transferable goodwill.

Adjusted book value is the measure of a company’s valuation after liabilities including off-balance sheet liabilities and assets adjusted to reflect true fair market value. The potential downside of using adjusted book value is that a business could be worth more than its stated assets and liabilities because it fails to value intangible assets, account for discounts, or factors in contingent liabilities. However, it’s not often accepted as an accurate picture of a profitable company’s operating value; however, it can be a way of capturing potential equity available in a firm.

Goodwill represents the benefits that a potential purchaser can obtain in an acquisition that is above and beyond the business’ net tangible assets. In other words, it is the premium that a buyer is willing to pay for a business, over and above its physical assets. Goodwill may include favourable branding, established products and service lines, customer relationships, and reputation within the industry, among others.

Adjusted book value approaches are generally used when there is no reasonable expectation of commercial goodwill.  Consider the following three scenarios:

• The company is an investment or real estate holding company;
• The company has active business operations that do not generate sufficient earnings to realize a reasonable return on the net assets; and/or
• The company is an operating business where all of the income is attributable to personal goodwill.

The Formula of Adjusted Book Value Approach

Below is a formula of how we calculate the adjusted net book value. We start with the shareholders’ equity on the financial statements, add any stub period after tax income/losses, adjust assets and liabilities to the fair market value as at the valuation date, and consider any disposition costs and income taxes arising from the notional sale. We then arrive at the adjusted net book value of the business.

Adjusted book value = Shareholders’ equity per Financial Statements +/- After-tax income (loss) for stub period +/- Adjustments of assets and liabilities to market value – Disposition costs on the sale of the assets – Taxes on the sale of the assets

Special Considerations

Adjusting the book value of a firm entails line-by-line analysis. Some are straightforward such as cash and short-term debt. These items are already carried at the fair market value on the balance sheet.

The value of receivables may have to be adjusted, depending on the age of the receivables. For example, receivables that are 180 days past due (and likely doubtful) will get a haircut in value compared to receivables under 30 days. Inventory can be subject to adjustment, depending on the inventory accounting method. If a firm employs the Last In, First Out (LIFO) method, the LIFO reserve must be added back.

Property, plant, and equipment (PP&E) is subject to large adjustments, particularly the land value, which is held on the balance sheet at historical cost. The value of the land would likely be far greater than the historical cost in most cases. Estimates for what buildings and equipment would fetch in the open market must be made.

The adjustment process becomes more complicated with things like intangible assets, contingent liabilities, deferred tax assets, or liabilities, and off-balance sheet (OBS) items. Also, minority interests, if present, will call for more adjustments to book value. The goal is to mark each asset and liability to fair market value. After the values of all the assets and liabilities are adjusted, the analyst must simply deduct the liabilities from the assets to derive the fair value of the firm.