What Is an Asset-Based Approach?

An asset-based approach is a type of business valuation that focuses on a company’s net asset value. The net asset value is identified by subtracting total liabilities from total assets. There is some room for interpretation in terms of deciding which of the company’s assets and liabilities to include in the valuation and how to measure the worth of each.

Understanding an Asset-Based Approach

Identifying and maintaining awareness of the value of a company is an important responsibility for financial executives. Overall, stakeholder and investor returns increase when a company’s value increases, and vice versa.

There are a few different ways to identify a company’s value. Two of the most common are the equity value and enterprise value. The asset-based approach can also be used in conjunction with these two methods or as a standalone valuation. Both equity value and enterprise value require the use of equity in the calculation. If a company does not have equity, analysts may use the asset-based valuation as an alternative.

Many stakeholders will also calculate the asset-based value and use it comprehensively in valuation comparisons. The asset-based value may also be required for private companies in certain types of analysis as added due diligence. Furthermore, the asset-based value can also be an important consideration when a company is planning a sale or liquidation.

Calculating Asset-Based Value

In its most basic form, the asset-based value is equivalent to the company’s book value or shareholders’ equity. The calculation is generated by subtracting liabilities from assets.

Often, the value of assets minus liabilities differs from the value reported on the balance sheet due to timing and other factors. Asset-based valuations can provide latitude for using market values rather than balance sheet values. Analysts may also include certain intangible assets in asset-based valuations that may or may not be on the balance sheet.

Adjusting Net Assets

One of the biggest challenges in arriving at an asset-based valuation is adjusting net assets. An adjusted asset-based valuation seeks to identify the market value of assets in the current environment. Balance sheet valuations use depreciation to decrease the value of assets over time. Thus, the book value of an asset is not necessarily equivalent to the fair market value.

Other considerations for net asset adjustments may include certain intangibles that are not fully valued on the balance sheet or included on the balance sheet at all. Companies might not find it necessary to value certain trade secrets. However, since an adjusted asset-based approach looks at what a company could potentially sell for in the current market, these intangibles are important to consider.

In an adjusted net asset calculation, adjustments can also be made for liabilities. Market value adjustments can potentially increase or decrease the value of liabilities, which directly affects the calculation of adjusted net assets.

What Is Advanced Internal Rating-Based (AIRB)?

An advanced internal rating-based (AIRB) approach to credit risk measurement is a method that requests that all risk components be calculated internally within a financial institution. Advanced internal rating-based (AIRB) can help an institution reduce its capital requirements and credit risk.

In addition to the basic internal rating-based (IRB) approach estimations, the advanced approach assesses the risk of default using loss given default (LGD), exposure at default (EAD), and the probability of default (PD). These three elements help determine the risk-weighted asset (RWA) that is calculated on a percentage basis for the total required capital.”

Understanding Advanced Internal Rating-Based Systems

Implementing the AIRB approach is one step in the process of becoming a Basel II-compliant institution. However, an institution may implement the AIRB approach only if they comply with certain supervisory standards outlined in the Basel II accord.

Basel II is a set of international banking regulations, issued by the Basel Committee on Bank Supervision in July 2006, which expand upon those outlined in Basel I. These regulations provided uniform rules and guidelines to level the international banking field. Basel II expanded the rules for minimum capital requirements established under Basel I, provided a framework for regulatory review, and set disclosure requirements for assessment of capital adequacy. Basel II also incorporates credit risk of institutional assets.

Advanced Internal Rating-Based Systems and Empirical Models

The AIRB approach allows banks to estimate many internal risk components themselves. While the empirical models among institutions vary, one example is the Jarrow-Turnbull model. Originally developed and published by Robert A. Jarrow (Kamakura Corporation and Cornell University), along with Stuart Turnbull, (University of Houston), the Jarrow-Turnbull model is a “reduced-form” credit model. Reduced form credit models center on describing bankruptcy as a statistical process, in contrast with a microeconomic model of the firm’s capital structure. (The latter process forms the basis of common “structural credit models.”) The Jarrow–Turnbull model employs a random interest rates framework. Financial institutions often work with both structural credit models and Jarrow-Turnbull ones, when determining the risk of default.

Advanced Internal Rating-Based systems also help banks determine loss given default (LGD) and exposure at default (EAD). Loss given default is the amount of money to be lost in the event of a borrower default; while exposure at default (EAD) is the total value a bank is exposed to at the time of said default.

Advanced Internal Rating-Based Systems and Capital Requirements

Set by regulatory agencies, such as the Bank for International Settlements, the Federal Deposit Insurance Corporation, and the Federal Reserve Board, capital requirements set the amount of liquidity is needed to be held for a certain level of assets at many financial institutions. They also ensure that banks and depository institutions have enough capital to both sustain operating losses and honor withdrawals. AIRB can help financial institutions determine these levels.