Substance Value Method

Substance Value Method: Fundamentals and Application

Introduction to the Substance Value Method

The substance value method is a classic approach to business valuation that focuses on assessing a company’s assets. The core objective is to determine the substance value, which is calculated as the sum of all assets minus liabilities. This method is commonly applied in capital-intensive industries or companies with stable, clearly definable assets, such as manufacturing or real estate sectors.

The substance value method fundamentally differs from income-based valuation approaches like the discounted cash flow (DCF) method. While the latter incorporates future cash flows and growth projections, the substance value method centers on evaluating existing tangible and intangible resources. This makes it particularly suitable for liquidation valuations or companies with limited earning power but significant assets.

This valuation method offers transparency and a clear structure but also has its limitations. It does not account for future earning opportunities or growth forecasts and is therefore less suitable for growth-oriented companies. Nevertheless, the substance value method remains an important tool, especially in scenarios where asset valuation is the primary focus.

Fundamentals of the Substance Value Method

The substance value method is based on a detailed assessment of all a company’s assets, including both physical and intangible assets. The substance value results from the difference between the estimated values of assets and liabilities. The goal is to determine the "pure" value of the company, independent of future profits or earnings.

In practice, two variants of the substance value method are distinguished: the book substance value and the actual substance value. The book substance value is based on the book values of assets recorded in the company’s balance sheet, whereas the actual substance value considers market values or replacement costs of the assets. The latter approach is generally preferred as it provides a more realistic estimate of the company’s value.

The substance value method is particularly relevant in cases where a company is to be shut down or liquidated. In such scenarios, the focus is on the sale value of assets, as future earnings are irrelevant. However, it is also a meaningful method for companies with extensive fixed assets or valuable intangible assets such as patents or trademarks.

Valuation of Fixed Assets

Valuing fixed assets is a central component of the substance value method. Fixed assets include physical assets such as machinery, buildings, land, and technical equipment essential for business operations. These assets are valued either based on their current market values or their replacement costs.

The market value approach values assets at their estimated selling price on the open market. This is particularly useful if the company plans to sell assets or be liquidated. Alternatively, the replacement cost approach considers the expenses required to replace the assets in their current condition. This approach is often used when the company is to continue operations and the focus is on the operational functionality of the assets.

For example: A manufacturing company owns machinery with a book value of 1 million euros recorded in the balance sheet. However, the market value of this machinery is 1.5 million euros due to increased demand for this type of equipment. In such a case, the actual substance value would be based on the market value to provide a more realistic valuation of the company. This method offers a clear and transparent basis for accurately determining the value of physical assets.

Valuation of Intangible Assets

In addition to physical fixed assets, intangible assets play an increasingly important role in the substance value method. Intangible assets such as patents, trademarks, software, or customer lists can significantly contribute to company value, especially in technology-driven industries or companies with a strong brand focus. However, valuing these assets is often complex, as there are no direct market prices and the value heavily depends on future earnings.

Various approaches are used to value intangible assets. The license fee analogy is a common method, where the value of an intangible asset is estimated based on the license fees a third party would pay for its use. Another method is the market comparison approach, which uses similar transactions as a basis for valuation. For example, the value of a brand could be derived by comparing it with the acquisition of a company with a similar brand portfolio.

For instance: A technology company owns a patent that generates license fees of 500,000 euros per year. Based on the license fee analogy, the patent’s value could be estimated at 5 million euros, assuming a ten-year term and an appropriate discount factor. These approaches require careful assumptions and data to ensure as realistic a valuation as possible.

Advantages of the Substance Value Method

The substance value method offers clear advantages, particularly for companies with substantial asset holdings or in situations where future earnings are not central. Its transparency and traceability make it especially suitable for industries with stable and clearly assessable assets, such as real estate, manufacturing, or energy sectors. Moreover, it is an indispensable method when a company is to be liquidated, as it precisely reflects the value of assets in a sales process.

Another advantage of the method lies in its flexibility. It can be applied to both physical assets and intangible values, making it versatile. By focusing on substance and current market values, the method often delivers robust results that are less affected by market fluctuations than income-based approaches. Combined with other valuation methods, it can also provide a valuable complement to create a comprehensive picture of company value.

Challenges and Limitations

Despite its strengths, the substance value method is not without limitations. It does not consider future earning potential and is therefore often less suitable for growth-oriented or innovative companies. A technology company with high development costs and low current substance but significant expected future profits would be severely undervalued if this method were applied exclusively.

Another challenge lies in the precise valuation of intangible assets. The value of brands, patents, or customer relationships is often difficult to quantify and depends on numerous assumptions. Additionally, market values of physical assets can fluctuate, affecting valuation accuracy. These uncertainties require combining the substance value method with other approaches such as the DCF method or the multiples method to enable a more comprehensive valuation.

Ultimately, the substance value method remains a valuable addition to the business valuation toolkit. It is particularly useful when the focus is on the current asset structure and future earnings are not the primary concern. By considering both physical and intangible assets, it can provide a stable foundation for valuation that can be further refined by other methods.