Valuing Machinery and Equipment (M&E) assets differs from other appraisal disciplines because an item’s value can differ depending on the specific circumstances of examination, such as liquidation value, going concern value and/or installation costs. This article will provide some insight into the terminology and methodology used by professional Machinery & Equipment appraisers as they develop an opinion of value.
When valuing all assets, the appraiser must determine which of the three standards of value (Fair Market Value, Fair Value (ASC 820) and Fair Value (Statutory) to utilize and which of three general approaches to value that can be applied to determine an opinion of value. Because of that, it is imperative for a client to specify to the appraiser exactly how the appraisal will be used. One of the critical parts of a “quality” M&E appraisal is a proper application of the definition of value to the reason for conducting the appraisal. Client needs dictate what details and support will be necessary to pass third party reviews of auditors, financial institutions and governmental agencies.
The major difference that sets an M&E appraisal apart from other tangible asset appraisals is the cost of installation. For many assets, the installation costs can exceed the costs of the equipment or machinery. Accordingly, used market machinery transactions will not represent an asset’s value to the enterprise.
Methods of Valuation
There are three recognized ways to determine value in appraisal analysis:
The Cost Approach is the starting point for many appraisals and is based upon the principle of substitution, meaning the maximum value of a property to a knowledgeable buyer would be the amount currently required to construct or purchase a new asset of equal utility. When the subject asset is not new, the current cost must be adjusted for all forms of depreciation as of the effective date of the appraisal.
The Direct Market or Sales Comparison Approach is based on the assumption that the value of an asset can be determined through the examination of transactions of identical or similar items selling in a secondary or used market, and adjusted for differences in age, condition, capacity, utility, location, the date of the sale, the type of sale, and/or the costs of transportation, assembly and installation at a new site.
The Income Approach examines the earning capacity of the business assets being investigated and can be very useful but is the least common method of valuing individual pieces of machinery and equipment.
It is important to keep in mind that a credible opinion of value cannot always be obtained with the application of a single methodology. It is through the judicious application of these methodologies that is gained through the proper surveying and inspection of the subject property, when combined with the experience and judgment of an objective, qualified, independent and certified professional appraiser that yields a quality appraisal.
Classification
The first step in the M&E appraisal process is to properly classify the asset(s) to be valued into two classifications:
Marketable Equipment is less challenging to value than special purpose equipment because of the available data to support their reproduction or replacement cost new and used market estimates. Points of reference can be developed and used to deduce, support and bracket the value of the subject asset.
Special Purpose Equipment only has Replacement Cost New as a point of reference for valuation. Any particular deficiencies in utility or obsolescence must be considered and analyzed on a case by case basis with the loss in value accordingly reflected.
Premises to Value
For each of the three Standards of Value mentioned above, we present a non-exhaustive list of sixteen (16) premises of value that can be determined:
- Replacement Cost New
- Reproduction Cost New
- Historical Cost
- Insurance Replacement Cost New
- Insurance Reproduction Cost New
- Original Cost
- Fair Market Value Severed
- Fair Market Value In Place (VIP)
- Fair Market Value In Use (VIU)
- Actual Cash Value
- Liquidation Value In Place (LVIP)
- Orderly Sale Value (OSV)
- Forced Liquidation Value (FLV)
- Orderly Liquidation Value (OLV)
- Scrap Value
- Salvage Value
Depreciation
Once the proper level of current cost new has been determined, deductions from this value must be taken for all forms of depreciation. Three types or causes of depreciation must be considered by appraisers:
Physical Deterioration is the loss in value or usefulness of an asset that occurs as a result of the using up or expiration of its’ useful life over time, exposure to natural elements or the process area environment, internal defects from vibration and operating stress, and other similar factors.
Functional Obsolescence is the loss in value or usefulness of an asset that is caused by inefficiencies or inadequacies of the asset itself, when compared to more efficient less costly replacement technology.
Economic Obsolescence is the loss in value or usefulness of an asset that is caused by factors that are external to the asset, for example- increased cost of raw materials, labor or utilities (without an offsetting increase in product price), new environmental regulations, reduced demand for the product, increased competition, inflation, high interest rates or other similar contributing factors.
Direct Market Comparison Approach to Value
Machinery and Equipment appraisers use the Direct Market Comparison (or Sales Comparison) approach to indicate value by analyzing recent sales (or offering) prices of assets that are comparable to the assets that are the subject of the appraisal. The transaction or offering dates of comparable assets must be scrutinized for applicability (active/verifiable market) to ensure that they are relevant. Additionally, if characteristics of the comparable assets are not identical to the subject, the comparable selling prices must be adjusted to place the comparable and subject assets on an equal basis.
Basically, the procedure is to gather sales and offerings data, determine appropriate units for comparability, analyze the available data and make adjustments as may be necessary. The used equipment market is usually priced on an uninstalled (dissociated) basis. Depending on the premise of value under consideration, costs of delivery, installation and taxes may need to be added to the market values.
As with the Cost and Income approaches to value, the Direct Market Comparison method to value assumes that an informed purchaser would pay no more for the asset than the cost of purchasing a comparable asset with the same utility elsewhere. Often in a Cost Approach to value, the appraiser will seek values of selected assets using the Direct Market Comparison method to validate the values that were obtained using the cost approach.
Income Approach to Value
The value of an asset can be estimated by the anticipated future benefit to the owner. The Income Approach to value is not widely utilized by Machinery and Equipment appraisers because of the difficulty associated with attributing a sites’ or business’ income to individual assets. When properly applied the income approach can confirm or enhance the credibility of the values arrived at when using the Cost or Direct Market approaches to value.
Two methods are often used to value machinery and equipment by the income approach, (a) the Direct Capitalization approach and (b) the Discounted Cash Flow (DCF) approach. When applying the Direct Capitalization method, a projected income stream (constant dollars) is divided by a capitalization rate. The Discounted Cash Flow approach projects quantity, variability, timing, period of duration and residual value and discounts them to a present value using a discount rate.
These approaches establish the value of an asset or collection of assets assuming an ongoing concern or business. This implies that the subject assets will remain in place and in use as a continuing or on-going concern at their highest and best use.
Conclusion
Quality appraisals are the direct result of selecting and applying the proper definition of value to meet the needs of a client. While the client may define their needs and the intended use of the appraisal, it is the appraiser’s responsibility to determine and apply the proper premise of value in order to match the intended use. The valuation process is a systematic procedure that answers client question- “How much is this worth?” The goal of the valuation process is to deliver to the client a well-supported opinion of value that shows that the appraiser has considered all factors materially affecting the asset being appraised.
