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CHAPTER 3
VALUATION APPROACHES AND
METHODS
Course Code: B
7/30/2020 B02036 – Chapter 3: Valuation Approaches and Methods (^1)
Ton Duc Thang University Finance and Banking Faculty Corporate Finance Department
Prepared by: Corporate Finance Department
COURSE CONTENT
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Introduction
Market Approach
Market Approach Methods
Income Approach
Income Approach Methods
Cost Approach
Cost Approach Methods
Depreciation/Obsolescence
INTRODUCTION
Consideration must be given to the relevant and appropriate valuation approaches. The principal valuation approaches are:
Three approaches are all based on the economic principles of price equilibrium, anticipation of benefits or substitution.
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Market approach
Income approach
Cost approach
INTRODUCTION
Each of these valuation approaches includes different, detailed methods of application.
The goal in selecting valuation approaches and methods for an asset is to find the most appropriate method under the particular circumstances.
No one method is suitable in every possible situation.
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Selecting Valuation Approaches
And Methods
Valuers n ot required to use more than one method for the valuation of an asset. However, valuers should consider the use of multiple approaches and methods and more than one.
Where more than one approach and method is used, or even multiple methods within a single approach, the conclusion of value based on those multiple approaches and/or methods should :
Be reasonable and the process of analysing and reconciling the differing values into a single conclusion, without averaging
Be described by the valuer in the report.
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Selecting Valuation Approaches
And Methods
When different approaches and/or methods result in widely divergent indications of value, a valuer should :
perform procedures to understand why the value indications differ;
reconsider the guidance to determine whether one of the approaches/methods provides a better or more reliable indication of value.
maximise the use of relevant observable market information in all three approaches.
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Selecting Valuation Approaches
And Methods
Regardless of the source of the inputs and assumptions used in a valuation, a valuer must perform appropriate analysis to evaluate those inputs and assumptions and their appropriateness for the valuation purpose.
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Selecting Valuation Approaches
And Methods
Although no one approach or method is applicable in all circumstances, price information from an active market is generally considered to be the strongest evidence of value.
Some bases of value may prohibit a valuer from making subjective adjustments to price information from an active market.
Price information from an inactive market may still be good evidence of value, but subjective adjustments may be needed.
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MARKET APPROACH
The market approach should be applied and afforded significant weight under the following circumstances:
(a) the subject asset has recently been sold in a transaction appropriate for consideration under the basis of value;
(b) the subject asset or substantially similar assets are actively publicly traded, and/or
(c) there are frequent and/or recent observable transactions in substantially similar assets.
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Market Approach Methods
Comparable Transactions Method
The comparable transactions method, also known as the guideline transactions method, utilises information on transactions involving assets that are the same or similar to the subject asset to arrive at an indication of value.
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KEY STEPS
(f) if multiple valuation metrics were used, reconcile the indications of value.
(e) apply the adjusted valuation metrics to the subject asset;
(d) make necessary adjustments;
(c) perform a consistent comparative analysis of qualitative and quantitative similarities and differences between the comparable assets and the subject asset;
(b) identify the relevant comparable transactions and calculate the key valuation metrics for those transactions;
(a) identify the units of comparison;
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COMPARABLE TRANSACTIONS
A single transaction or event;
Similar assets (ideally identical) provides a better indication of value than assets where the transaction prices require significant adjustments ;
Transactions that happen closer to the valuation date;
For most bases of value, the transactions should be “arm’s length” between unrelated parties;
Sufficient information on the transaction;
Information should be from a reliable and trusted source;
Actual transactions;
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INCOME APPROACH
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INCOME APPROACH
The income approach provides an indication of value by converting future cash flow to a single current value.
Under the income approach, the value of an asset is determined by reference to the value of income, cash flow or cost savings generated by the asset.
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INCOME APPROACH
The income approach should be applied and afforded significant weight under the following circumstances:
(a) the income-producing ability of the asset is the critical element affecting value from a participant perspective;
(b) reasonable projections of the amount and timing of future income are available for the subject asset , but there are few, if any, relevant market comparables.
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INCOME APPROACH
A fundamental basis for the income approach is that investors expect to receive a return on their investments and that such a return should reflect the perceived level of risk in the investment.
Generally, investors can only expect to be compensated for systematic risk (also known as “market risk” or “undiversifiable risk”).
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TYPE OF CASH FLOW
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Cash flow to whole asset or partial interest; The cash flow can be pre-tax or post-tax; Nominal versus real; Currency; Note: The type of cash flow chosen should be in accordance with participant’s viewpoints.
Explicit Forecast Period
The selection criteria will depend upon the purpose of the valuation , the nature of the asset , the information available and the required bases of value.
For an asset with a short life, it is more likely to be both possible and relevant to project cash flow over its entire life.
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Explicit Forecast Period
Valuers should consider the following factors when selecting the explicit forecast period:
(a)the life of the asset;
(b)a reasonable period for which reliable data is available;
(c) the minimum explicit forecast period which should be sufficient for an asset to achieve a stabilised level of growth and profits, after which a terminal value can be used;
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CASH FLOW FORECASTS
Be constructed using prospective financial information (PFI);
Be divided into suitable periodic intervals with the choice of interval depending upon the nature of the asset , the pattern of the cash flow, the data available, and the length of the forecast period.
Capture the amount and timing of all future cash inflows and outflows associated with the subject asset from the perspective appropriate to the basis of value.
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DISCOUNT RATE
(a) the risk
(b) the type of asset being valued.
(c) the rates implicit in transactions in the market,
(d) the geographic location of the asset and/or the location of the markets (e) the life/term of the asset and the consistency of inputs.
(f) the type of cash flow ;
(g) the bases of value being applied.
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COST APPROACH
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COST APPROACH
The cost approach provides an indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction, unless undue time, inconvenience, risk or other factors are involved.
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COST APPROACH
The approach provides an indication of
value by calculating the current
replacement or reproduction cost of an
asset and making deductions for
physical
deterioration and all other relevant
forms of obsolescence
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Cost Approach Methods
(a) replacement cost method: a method that indicates value by calculating the cost of a similar asset offering equivalent utility;
(b) reproduction cost method: a method under the cost that indicates valueby calculating the cost to recreating a replica of an asset;
(c) summation method: a method that calculates the value of an asset by the addition of the separate values of its component parts.
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Replacement Cost Method
Replacement cost is the cost that is relevant to determining the price that a participant would pay as it is based on replicating the utility of the asset , not the exact physical properties of the asset.
Replacement cost is adjusted for physical deterioration and all relevant forms of obsolescence. After such adjustments, this can be referred to as depreciated replacement cost.
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Key steps in the
replacement cost method
(a) calculate all of the costs that would be incurred by a typical participant seeking to create or obtain an asset providing equivalent utility;
(b) determine whether there is any deprecation related to physical, functional and external obsolescence associated with the subject asset;
(c) deduct total deprecation from the total costs to arrive at a value for the subject asset;
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Replacement Cost Method
The replacement cost is generally that of a modern equivalent asset , which is one that provides similar function and equivalent utility to the asset being valued, but which is of a current design and constructed or made using current cost-effective materials and techniques.
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