Cost approach

The cost approach asks the simplest question in valuation: what is actually there?

It adds up the assets, subtracts the liabilities, divides by the shares outstanding, and stops. It takes no view of what the business might earn in future. That is both its weakness — the workbook says plainly that it does not consider some critical drivers of value the way the income approach does — and its usefulness, because it produces a number that does not depend on anybody's forecast.

It is also the approach nobody treats as complete. The workbook calls it not an independent method: where it is used at all, it is usually combined with others under weights reflecting how much it deserves to count in that particular case.

Chapter 11 sets out three routes, each answering a different question.

1. Book value or Net Asset Value. Assets and liabilities at their historical carrying cost in the books. Book value per share is normally treated as the floor price — the least a going concern should be worth.

2. Replacement cost. What it would cost to rebuild the entire business as-is-where-is: the market cost of the assets and liabilities with suitable adjustments, plus the costs of establishing the business as a going concern in its present state — licences, registrations, approvals, pre-operative costs. Appropriate for businesses with high entry barriers or set-up costs.

3. Break-up value. The salvage value if the business were shut down on the valuation date and sold off in pieces. Used for a company in distress or without a future business case.

One subtlety worth learning: the revaluation reserve is excluded from the cash net worth computation, because it represents a writing-up of assets rather than value the business generated.

IPEV treats the same method as appropriate where an investee company is not performing satisfactorily and incurring losses, or is in the business of finance and investments — which is also where the workbook says the approach is ideal.

Book value per share  = Equity shareholders' funds as per balance sheet
                        ÷ Number of equity shares issued and paid up

Break-up value        = (Liquidation value of assets
 per share              − settlement value of debt)
                        ÷ Number of equity shares issued and paid up

Illustration 11.4. Alpha Ltd, 10,000 shares outstanding, balance sheet totalling Rs 2,00,00,000, with fixed assets of Rs 1,20,00,000, inventory Rs 35,00,000, receivables Rs 25,00,000, intangibles Rs 10,00,000 and trade payables Rs 10,00,000. On liquidation, fixed assets fetch 40 per cent of book value; on a going concern basis their market value is 10 per cent lower. Inventory would cost 10 per cent more in the market, receivables fetch 25 per cent less, payables settle 15 per cent lower. Set-up costs of Rs 20,00,000 would be incurred afresh, and the trademarks and patents would fetch Rs 5,00,000 more than book.

I. Book value

The revaluation reserve of Rs 15,00,000 is left out.

II. Break-up value

III. Replacement value

Three defensible numbers for the same company on the same day: Rs 1,010 and Rs 327.50 a share of equity value, and Rs 2.165 crore of enterprise value. Which one is right depends entirely on whether the company keeps trading, is broken up, or is being rebuilt from scratch by a buyer.

Chapter 11 (Valuation), sections 11.4 and 11.5, with Illustration 11.4 worked through all three methods; and section 11.8.3, where IPEV recommends net asset valuation for loss-making or finance-and-investment businesses. Expect a computation of book value or break-up value per share from a balance sheet with adjustments, and a matching question on which method suits which situation.

• The balance sheet in Illustration 11.4 is headed "Rs. crore" but the figures are plain rupees — total assets of Rs 2,00,00,000 across 10,000 shares give an NAV of Rs 1,010, not Rs 1,010 crore. Read the numbers, not the column heading; the heading is a printing error.
• Exclude the revaluation reserve from cash net worth. It is not cash and the workbook footnotes the exclusion.
• Match the method to the situation. Replacement cost for high entry-barrier businesses; break-up for distressed companies or those without a future business case; book value as the floor for a going concern.
• Replacement value here is an enterprise value, while book value and break-up value are equity values. They are not comparable without adjusting for debt.
• Cost approach is not an independent method. Use it with others under weights, not on its own.
• Break-up value counts assets at liquidation prices and debt at settlement value — both differ from book, and in opposite directions.