The Asset Approach measures the fair market value of a childcare center’s assets, less its liabilities, is frequently used for underperforming childcare center businesses. This asset approach is not appropriate for childcare businesses that are doing well.
The owner of a childcare businesses often own the real estate used by the center. Underperforming childcare centers, or childcare centers in trouble, often do not make enough money to support a fair market value rent of the real estate that is used by the business. In this case, the value of the real estate is lower, and in some cases, much lower, than what the market value of the real estate would have been if the center was doing well.
What Happens When Cash Flows Will Not Support The Purchase Of Both The Real Estate And Business?
The Adjusted Book Value or Asset Approach To Valuation
When a childcare centers owners owns both the childcare business and the real estate it operates in, when the owner is ready to sell her center, she often wants to sell both the business and the real estate. Buyers also often want to buy both the childcare business and real estate.
Childcare center real estate is often more valuable than the business, and should always be appraised separately from the business value. However, the real estate is an integral part of the function of a childcare center business.
What happens when cash flows will not support the purchase of both the real estate and business?
The asset approach to business valuation views the business assets on the balance sheet as what creates value. The asset approach is based on the economic principle of substitution. It answers this question: “What will it cost to create another childcare business like this one that will produce the same economic benefits for its owners?”
The Assets are valued at adjusted book value. The answer to what the assets are worth is difficult, and depends on the situation. For example, to replace a center’s currently used furniture (with a depreciated book value of, for example, $100k) could cost $200k if bought new, but the furniture, as is, may, if bought used, only cost 10% to 20% of the new cost.
Even if the childcare business is not profitable, and is operating at say 50% of capacity, if a person were to create another childcare center business, it may take them nine to twelve months before the center even gets up to the breakeven point, in which case the person starting the center will be sustaining losses during those months; therefore, the fact that the center has enrolled children has a value.
The difficulty with the asset approach to valuation is that it looks at all of the business assets as having value in and of themselves, without regard to if the childcare center is a going concern. However, businesses hold assets primarily as a means of generating future cash flows.
If the total assets used in the childcare center to create cash flow (including both business and real estate assets) don’t produce a cash flow that supports those assets, then buyers who buy with the intent of operating a childcare center will generally only offer a price which is supported by the cash flow of the existing childcare center, even if that price is substantially less than the valuation using the “Asset Approach”. For example, if the cash flow of a childcare center will only support a $1.6 million purchase price, even though the real estate is worth $2 million using the “asset approach”, the center (real estate and business combined) will likely only sell for the $1.6 million.
Since, childcare center real estate is often “special use assets” that can be expensive to convert to other uses. For example, if the real estate of a 10k square feet childcare center is worth $2 million, and it would take a buyer $600,000 to convert it to say a veterinarian, medical or dental office, that buyer who would convert it to a medical office may only offer $1.4 million.