Book Reviews, Valuation

Book Review on Valuation: What Assets are Really Worth

Book: Valuation: What Assets Are Really Worth by Alfred M. King

Review: Good book on Valuation as a profession and how to value all kinds of things.

Key Points:

  1. Cost, Value, and Price
    • Appraisers determine value. Cost and selling price are aids in determining value.
    • Value is the amount at which willing buyers/sellers are willing to transact as when both parties had full knowledge and were under no pressure to buy or sell.
    • Insurable values are usually based on the cost of reproduction.
    • Financing value will be based on liquidation value.
    • Replacement cost less depreciation is an asset’s value in use.
  2. Key Questions an Appraiser Asks
    • What is the purpose of the valuation
    • How will it be used
    • Exact date of the valuation
  3. Special purpose assets (e.g. commercial bakery, semiconductor facility) can be valued in terms of their original cost if they are to continue to be used for their special purpose. If not, there needs to be a cost penalty to allow for the cost of putting the building in shape for its next intended use.
  4. Joint ventures
    • Determine the enterprise value of the JV
    • Value the easier contributions, e.g. cost approach can be used to value marketing (e.g. cost for travel, training, office space, support) because if not, a replicating cost needs to be paid by the other partner.
    • Value of the tough contribution (e.g. new product invention) = Enterprise value of JV minus Value of easier-to-value contributions
  5. Divorce
    • Try to get both parties to agree on the projections for the privately held firm.
    • No good solution, try to have reasonable assumptions using recently reported financial results.
  6. Loans
    • FIs lend usually 80% of value of accounts receivable, 65% of inventory value, 50% of PP&E.
  7. Gifts and Estate Tax
    • For private firms, calculate business enterprise value (BEV), take discount for lack of marketability (~25%), take discount for lack of control (~35%)
  8. Cost Approach to Value
    • Start off with cost for new item (usually replacement cost)
    • Less physical depreciation (need to estimate useful life)
    • Less functional depreciation (accounts for performance difference. E.g. cost penalty of an old plant = cost per unit of output from the new plant – cost per unit of output from the old plant. Take the excess costs if using the old plant and do a PV. The PV is the depreciation charge for functional obsolescence because that is how much cheaper the old plant needs to be sold, in comparison to a new plant).
    • Less economic depreciation (the plug in order for the final value to be equal to fair market value calculated by income method).
    • = Fair market value
  9. Replacement Cost vs Reproduction Cost
    • Replacement cost represents what it would cost to acquire comparable assets that are available today.
    • Reproduction cost is the cost to reproduce the exact same item. Usually used by insurance as they want to repair to the same.
  10. Unique assets: Land and Fine Art cannot be valued using cost approach. Land can be valued using the income approach or market comparable approach. For fine art it is the selling price.
  11. Income Approach
    • Develop income projection, adjust to cash flow forecast. Standard FCF.
    • Start-up Businesses – Discount rate is usually 30 to 50% and above (typical rates demanded by angel investors and venture capital firms due to the high risk). Out of 10 businesses, 3-4 will fail, 4-5 will break even.
    • To address the problem of calculating a terminal value based on future cash flows from earnings, it is better to assume that the company will be sold at the end of the projection period (e.g. a cash in flow in year 6 due to the sale). The selling price can be estimated using Value Line P/E ratios applied to year 5 earnings.
  12. Market Comparable Approach
    • Real Estate – Look at past transactions around the area, adjust for time of sale, zoning, location (e.g. premium for nearby highway).
    • Machinery and Equipment
      • Check with dealers, look into liquidation auctions.
      • There is a 25% – 50% difference in the value between assets-in-place-and-ready-to-use vs what those assets could be realised in a sale (due to deinstallation costs, transportation, time value for holding inventory, profit margin for resale, etc.)
    • Publicly Traded Securities
      • To buy/sell in large blocks, there is around a 5% penalty due to the size of the trade.
      • Control premium is around 35%
      • Marketability discount is around 25% – 35%
    • Beware of relying too much on recent transactions (e.g. bubble conditions, credit crisis)
  13. Allocation of Purchase Price – Tangible Assets
    • Inventory – turns over quickly, usually not an issue.
    • Land – research land sales, adjust for relative size and location, adjust for time value of money for time taken to sell the land. Assumptions may be made on the zoning (e.g. can it be rezoned as industrial land rather than agricultural).
    • House – determine value of land, subtract it from the total purchase price; OR determine value of house independently.
    • Buildings – Market comps approach: find out what other similar buildings are selling for in the open market. Cost approach: what would it cost today to build the same building (replacement), then adjust for depreciation from all causes.
    • Machinery & Equipment – need to determine what is the premise of value: in use? in exchange?
      • Value-in-use of production M&E is the cost today to acquire the assets less depreciation from all causes, and not the capitalised future cash flows, because you can buy the same equipment at cost.
      • Value in exchange, get cost of new assets from manufacturing supplier, ask employees about maintenance policy, asset replacement, quality, operating cost, apply discount for depreciation from all causes.
      • Another way is to apply a price index to the original cost of the assets (not the value allocated to the asset in a previous M&A).
  14. Allocation of Purchase Price – Intangible Assets
    • Non-compete agreement – create two sets of projections, one with competition and one without. Difference in cash flow discounted back to today is the value of the non-compete agreement.
    • Assembled workforce
      • Look at cost of replacement, what has been spent to hire employees, including moving cost, training cost, wage and salary paid during training to bring them to the current state. For hourly and clerical workers, typically cost is equal to 3-4 months of wages. For executives it is much longer.
      • To calculate the length of time to amortize the value, look at actual employee turnover in the recent past, adjust for non-recurring items. If a firm consistently experienced 15% turnover per year, a 7-year life for the value of the assembled workforce is reasonable.
    • Software
      • For software sold, use income approach to project future income and cash flows. Most software has only 2-3 year life before a new version is needed. A dominant product will have a lower discount rate applied.
      • For internal software, use cost approach, i.e. how much it will cost today to replace or replicate the software. Analyse the time it would take today (having had the previous experience) multiplied by man-hour rates. A longer life of 6 – 10 years is supportable.
    • Supplier relationships – look at the cost of the procurement function capitalised over a 3-5 year period, including resources taken to identify the best suppliers and develop relationships.
    • Customer relationships and distribution channels – Income approach, or Cost approach, i.e. the cost of developing a customer base. Estimate the time taken to capture the market share of the company being appraised (e.g. 5 years). Quantify the cost over that period of providing higher quality (higher manufacturing cost), lower prices (lower gross profit), and direct selling and advertising (out-of-pocket costs) to accomplish the goal.
    • Brand names and trademarks – Use income approach. Estimate the incremental quantity of the product sold (compared to other normal products), and determine how much higher a price the seller is able to realise (compared to other normal products). Second way is to look at royalties paid on comparable products that are licensed.
    • Patents and unpatented technology – Income approach. Quantify the impact of the patent on cash flows. For a product line using multiple patents, it is more appropriate to value the product line.
    • Leasehold interests – If current contractual rent is less than market rates, this is an asset. Total value is to take the difference between market rate and contractual rate, and capitalise the savings per year till the end of the lease.
    • R&D in progress – Look at products or services under development, estimate the profit from future sales of the products or services, subtract the costs required to complete the R&D.
    • Subscription lists and databases – Value of such items usually go up (e.g. value of dictionaries go up with more entries added gradually). One way is to look at cost spent to date, another way is to estimate the future profit less the cost to complete the project.
  15. Look at SFAS 141 and SFAS 142.
  16. For startups, either use income approach or market approach. For market approach, pick a publicly traded company as starting point, then adjust for size, marketability discount, discount for being not as well capitalised, discount for shorter history, etc.


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