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 |
||
|
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
New Construction
Insurance
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:
-
Estimate the replacement or reproduction cost of the improvement (structure).
-
Estimate all the depreciation of the improvement (accrued depreciation).
-
Subtract accrued depreciation from the reproduction/replacement cost.
Accrued depreciation is the total of all the estimated depreciation.
-
Estimate the land value separately.
-
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
Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.