Valuation techniques Cost approach

Valuation techniques Cost approach – When valuing a company as a going concern there are three main valuation methods used by industry practitioners: the cost approach, the market approach and the income approach.  These are the most common methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO) and most areas of finance.

 

Valuing a Business, Group of assets (and liabilities) or a Cash generating unit

Cost approach

Market approach

Income approach

Cost to build

Precedent transactions

Forecast of business results

Replacement costs – the amount that would be required currently to replace the service capacity of an asset.

Comparable company transaction data

– Public company transactions

– Private company transactions

– Prior transactions of the subject company

Present value techniques discounting future cash flows using a risk adjusted discount rate

Multi-period excess earnings method

and others

Appraised value by a specialised industry expert – Validation of replacement calculation to objectify the value estimate.

Special purpose report by a specialised business valuator – Validation of data used to objectify the value estimate.

Special purpose report by a specialised business valuator – Comparison of valuation models and inputs used to objectify the value estimate.

The cost approach is used in specific cases, especially when the other approaches are not available (lack of market or income data) or produce unreasonable results. For example, the cost approach will likely be the most practical option to measure the fair value of Buckingham Palace, the Sydney Opera House or the White House (with the Sydney Opera House most likely to also have a market or income approach value). Valuation techniques Cost approach

The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost). From the perspective of a market participant seller, the price that would be received for the asset is based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. Valuation techniques Cost approach

That is because a market participant buyer would not pay more for an asset than the amount for which it could replace the service capacity of that asset. Obsolescence encompasses physical deterioration, functional (technological) obsolescence and economic (external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (using specified service lives). In many cases the current replacement cost method is used to measure the fair value of tangible assets that are used in combination with other assets or with other assets and liabilities. Valuation techniques Cost approach

Examples of Cost Approach 

Special Use Properties

The cost approach is required and sometimes the only way to determine the value of exclusive-use buildings, such as libraries, schools or churches. These resources generate little income and are not often marketed, which invalidates the income and comparable approaches. Valuation techniques Cost approach

New Construction

The cost approach is often used for new construction, too. Construction lenders require cost approach appraisals because any market value or income value is dependent upon project standards and completion. Projects are reappraised at various stages of construction to enable the release of funds for the next stage of completion. Valuation techniques Cost approach

Insurance

Insurance appraisals tend to use the cost approach because only the value of improvements is insurable and land value is separated from the total value of the property. The choice between depreciated value and full replacement or reproduction value is the determining factor for the evaluation. Valuation techniques Cost approach

Simple example

The formula for the cost approach is: Replacement or reproduction cost – depreciation + land value = value

A breakdown of the steps of this method follows:

  1. Estimate the replacement or reproduction cost of the improvement (structure).

  2. Estimate all the depreciation of the improvement (accrued depreciation).

  3. Subtract accrued depreciation from the reproduction/replacement cost.

    Accrued depreciation is the total of all the estimated depreciation.

  4. Estimate the land value separately.

  5. Add the depreciated cost of the structure to the land value.

Reproduction/replacement cost CU200,000
less: Accumulated depreciation – CU50,000
Depreciated value of improvements CU 150,000
Land value CU60,000
Total estimated value CU210,000

Valuation techniques Cost approach

Valuation techniques Cost approach

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