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Chapter Six
Asset Valuation for Financial Reporting
6.1 Basics of valuation

Asset valuation is the process of determining the fair market or present value of a company,
investment or an asset.

All companies deal with valuation from time to time. Capital budgeting, company and asset
valuation, or value based management rely on valuation.

Two approaches are the foundation of valuation, discounted cash flow valuation and relative
valuation. The first one is a bottom-up approach where the present value of an asset’s future cash
flows is calculated, the second determines the value of an asset by comparing it to similar other
assets.

While relative valuation is well applicable by common sense, discount cash flow (DCF) needs
considerable understanding of the relevant input parameters. As discount cash flow (DCF) is a
vital approach to valuation in life sciences and the basis of decision tree analysis and real options
valuation, it is worthwhile to discuss in detail how the method is properly applied.

Basis of Value explains a statement of fundamental measurement, principles of a valuation on a

specific date. A basis of valuation is not the statement of the method used, or a description of the
satellite of an asset or assets when being exchanged are neither an assessment foundation. First
of all, it explains beta, what Unlevered Beta means about Methodologies, the Terminal value,
WACC method, workmanship and ideas like Enterprise Value and the coverage of equity
finance. Once the foundation is taken into account, proceed with the assessment techniques such
as discounted cash flow, book value versus market value, free cash flow for the companies that
use these measurements.

6.2. Overview of International Valuation Standards (IVS)

A number of stakeholders use valuations for several purposes such as in the financial and capital
markets, for inclusion and exclusion in financial statements, for regulatory compliances or help
in secured lending transactional uses. In order to maintain parity and understanding regarding the
best valuation practices to be adopted and understood by all the stakeholders in the same sense,

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the International Valuation of Standards (IVSs) are the standards that consist of various actions
required to be undertaken while undertaking a valuation assignment supported by technical
information and guidance.
Objective of International Valuation Standards
The objective of International Valuation Standards (IVSs) is to cement the trust and confidence
of the users in valuations services by establishing a transparent valuation framework along with
consistent valuation procedures.
The IVSs contain five different types of pronouncements. These are as follows:
• IVS Framework
IVS framework provides the concepts and principles that need to be followed while applying the
IVFs. However, it does not include any required actions.
 IVS General Standards
IVS General Standards contain the actions that are required at the time of setting up, carrying
out and reporting a valuation.
 IVS Asset Standards
IVS Asset Standards contain the additional requirements for each of main genres of asset. It also
contains guidance on important issues which affects valuation of a particular type of asset that
needs to be considered.
 IVS Application Standards
IVS Application Standards contain some additional requirements for specified valuation purpose
and guidance on the matters that may be typically encountered.
 Technical Information Papers

Technical Information Papers contain the guidance on complying with specific requirements in
different standards or while dealing with matters where there is evidence of diverse practice.

Adoption of IVSs by different countries

A number of countries across the world have adopted IVSs and incorporated them in their
national systems of valuation. These countries include the states of Romania, Turkey, South
Africa, some emirates of UAE, Bahrain. Certain other countries have adopted IVSs as part of
their national standards and for that they have made amendments in their national laws. Such
countries are both Australia and New Zealand. An initiative has been taken by the professional
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organizations of the countries where they have adopted part or all IVSs for their members in
many countries such as China and Hong Kong.

IVSs have found their place in the IFRS Model Financial Statements released by two of the four
Big Four Accounting Firms namely Deloitte and Ernst & Young (EY). Even the European
Banking Authority (EBA) made references of IVSs in its new valuation handbook for central
banks and other prudential regulators in Europe.

Private Organizations have also confirmed to the IVSs signaling their commitment to
international standards related to professional valuations by becoming a member of IVSC.
6.3 Valuation approaches
A valuation approach is the methodology used to determine the fair market value of a business.
The most common valuation approaches are:
6.3.1 Market approach
The market approach is a method of determining the value of a business based on the selling
price of comparable businesses. The analyst can use either data on publicly traded companies, or
data on the sale of comparable privately owned companies. This method generally relies on
pricing multiples, usually of revenue or some measure of profit to arrive an indication of value.

The market approach is a method of determining the value of a business based on the selling
price of comparable businesses. The analyst can use either data on publicly traded companies,
or data on the sale of comparable privately owned companies. This method generally relies on
pricing multiples, usually of revenue or some measure of profit to arrive an indication of value.

Thus, the Market Approach relies on publicly available data for pricing data which can arise
from three primary sources:
 Sales transactions of similar companies
 Publicly-traded similar companies
 Sales of interests in the subject entity
Notice that the first two sources rely on pricing data for other companies whereas the last source
relies the subject company itself. Neither is a perfect apples-to-apples comparison given the
present-day subject company will have unique qualities that aren’t necessarily replicated in
comparable companies or weren’t present in its prior stages. Moreover, it’s possible that relying
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on more than one of these methods within the Market Approach would result in a more accurate
value for the subject company.

The following is an expanded version of the bulleted list that includes the widely accepted
industry names for each of these methodologies:
 Guideline Company Transaction Method – Sales transactions of similar companies

 Guideline Public Company Method – Publicly-traded similar companies

 Guideline Sales of Interests in Subject Company – Sales of interests in the subject entity
The Market Approach could be appropriate for a business when the following characteristics are
present:
 The pricing data for comparable is robust and readily available
 In situations where future cash flows are negative or highly unpredictable
Advantages

 The Market Approach is “forward-looking” because market prices reflect investor

expectations about the future
 Assumptions, adjustments, and third-party data are required, but the overall analysis is
typically less complex than the Income Approach
 The value derived considers all of the operating assets, including tangible and intangible
Disadvantages

 Insufficient or low-quality market data can limit the accuracy of the Market Approach or
render it unsuitable
 Key assumptions are often excluded; an example would be the growth expectations for
the comparable which can be available for public companies but rarely for private
comparable.
6.3.2 Income approach
The Income Approach - quantifies the net present value of future benefits associated with
ownership of the equity interest or asset. The estimated future benefits that accrue to the owner
are discounted or capitalized at a rate appropriate for the risks associated with those future
benefits. Common methods within the income approach include the capitalization of earnings (or
cash flow) methodology and the discounted cash flow methodology.

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The Income Approach is based on the premise that equity holders are investors, and they view
their ownership as they would any other investment. Financial theory holds that an investment is
a current commitment of money to an endeavor that will (hopefully) result in future payments to
the investor that are greater in value. The Income Approach is thus “forward-looking.” Further, it
discounts those future payments back to their present-day value, incorporating the risks and
opportunity costs inherent in any future project into the discount rate. The emphasis on future
cash flows is a unique attribute of this approach that distinguishes it from the other approaches.
The Income Approach could be appropriate for a business when the future cash flows have the
following characteristics:
 Future cash flows are positive
 Future cash flows are relatively stable – not highly volatile
 Future cash flows can be reliably forecasted for several years into the future
Advantages

 Focused on future cash flows which are of utmost importance to investors

 Unlike the Market Approach, the Income Approach is not as reliant on similar past
transactions or comparable companies which can never truly match the unique
characteristics of the subject company
 Unlike the Cost approach, the Income Approach considers value derived from both
tangible and intangible assets.
Disadvantages
 Not as relevant when valuing businesses that are years away from achieving positive cash

flow
 Potential to become highly complex and involve many underlying assumptions
6.3.3 Cost approach
This method determines fixed assets based on the purchase price of the asset. The cost (or asset-
based) approach derives value from the combined fair market value (FMV) of the business’s net
assets. This technique usually produces a “control level” value, meaning the value to an owner
with the power to sell or liquidate the company’s assets. For that reason, a discount for lack of
control (DLOC) may be appropriate when using the cost approach to value a minority interest.
This approach is particularly useful when valuing holding companies, asset intensive companies

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and distressed entities that aren’t worth more than their net tangible value.

The cost approach includes the book value and adjusted net asset methods. The former calculates
value using the data in the company’s books. Its flaws include the failure to account for
unrecorded intangibles and its reliance on historical costs, rather than current FMV. The adjusted
net asset method converts book values to FMV and accounts for all intangibles and liabilities
(recorded and unrecorded).

On the other hand, the asset-based approach usually ignores the value of intangible assets, such
as reputation, brand, customer relationships, and a well-trained workforce. As a result, it
frequently results in the lowest value of the three methods and may be used to set a “floor” for
the value of the business.

As previously discussed, the Cost Approach is typically used only in specific situations. Those
may include but are not limited to the following:
 For use in valuations for financial and tax reporting purposes when minimal progress has
been made on a company’s business plan

 For tangible asset-intensive businesses

 For investment, holding, and real estate companies where cash-flowing operations tend to
contribute less of the value than the underlying assets
 For small businesses where there is little or no goodwill
Advantages

 Does not rely on the challenging process of forecasting future cash flows
 Simple to understand and relatively straightforward to execute
Disadvantages

 Rarely applicable to operating companies because an earnings-based approach is likely

more relevant
 Does not directly value intangible assets so the valuation expert still needs to assess their
value separately or use an additional Cost Approach, such as a cost to recreate, to value
the intangible assets
Example: An appraiser I valuing storage building that is 10,000 sqft with $25,000 in on site
upgrade. The property is 15 years old. The economic life for the building is 50 years and the
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effective age of the building is 10 years old. The cost to build a new building is $100 per sqft. A
similar lot recently sold for $100,000 without the additional site improvements.
Required:
Using the cost approach calculate the value of the property rounded to the hundred dollars?
Given:

 Building square footage = 10,000 sqft

 Amount of upgrades = $25,000
 Age of the property = 15 year
 Economic Life (EL) = 50 years
 Effective age of the building (EA) = 10 years
 Cost to build new = $100 per sqft
 Similar lot recently sold = $100,000
Solution:
Step 1: Calculate the cost of the new building
10,000 sqft X $100 per sqft = $1,000,000

Step 2: Calculate depreciation

$1,000,000/50 year (EL) X 10 years (EA) = $200,000
Step 3: Determine the estimated property value
$1,000,000 –$200,000 + ($100,000 + $25,000) = $925,000
6.4 Valuation report
A valuation report is a professional assessment of the market value of a property by a certified
valuer. The report is based on the general condition of the home (observed via a visit), recent and
relevant sales history and other pertinent market data.

The property valuation report includes property information – rates, size of the land and building,
physical details on the construction and condition of the dwelling, details on any immediate
issues that may need addressing – as well as information on comparative sales in the area.

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