There are three general approaches to valuing any asset or interest in a business. The three approaches are commonly referred to as (1) the cost approach, (2) the market approach, and (3) the income approach. The FASB refers to the three approaches as valuation techniques. ASC 820, Fair Value Measurements and Disclosures, requires the application of three valuation techniques to measure the fair value of an asset or liability. Paragraph 18 states, “Valuation techniques consistent with the market approach, income approach, and/or cost approach shall be used to measure fair value”. These three valuation techniques are widely used by practitioners in the accounting, valuation, and appraisal industries.
The objective is to use a valuation technique (or combination of techniques) appropriate for the circumstances but maximize the use of market inputs. Fundamentally, value is a function of economics and is based on the return on assets. The cost approach represents the replacement or reproduction of things owned or borrowed. The income approach quantifies the return these net assets can be expected to produce. The market approach reflects the market’s perception of the things owned and borrowed and their expected returns.
The International Glossary of Business Valuation Terms defines the cost, market, and income approaches to valuation as follows:
. Cost Approach – A general way of estimating a value indication of an individual asset by quantifying the amount of money that would be required to replace the future service capability of that asset.
Historical Balance Sheet
[Current Asset + Net Fixed Asset + Other Asset] = [Current Liabilities + Long Term-Debt + Owner’s Equity]
Historical Balance Sheet
[Current Asset + Tangible Assets + Intangible Asset + Goodwill] = [Current Liabilities + Long-Term Debt + Owner’s Equity]
Economic Balance Sheet
Weighted Average Return On Asset = Weighted Average Cost of Capital
Net Working Capital = Interest Bearing Debt
+Tangible Assets + Owner’s Equity
. Market Approach – A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.
. Income Approach – A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that convert anticipated benefits to a present single amount. [International Glossary of Business Valuation Terms, 2001].
Although SFAS 157’s definitions of these valuation approaches are more specific and apply only to measuring fair value for financial reporting they are generally consistent with valuation approach definitions from the valuation profession.
Paragraph 19 of SFAS 157 goes on to say:
Valuation techniques that are appropriate in the circumstances and for which sufficient data are available shall be used to measure fair value. In some cases, a single valuation technique will be appropriate . . . In other cases, multiple valuation techniques will be appropriate . . . If multiple valuation techniques are used to measure fair value, the results shall be evaluated and weighted, as appropriate, considering the reasonableness of the range indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances.
The provisions for selecting and weighing valuation techniques in SFAS 157 are consistent with practices within the valuation industry.
The American Institute of Certified Public Accountants (AICPA) issued Statement on Standards for Valuation Services No. 1 “Valuation of a Business, a Business Ownership Interest, Security or Intangible Asset” in June 2007, which represents generally accepted practices and procedures within the valuation profession.
According to the statement:
- The valuation analyst should use all valuation approaches that are appropriate after considering the use of the income, market, and asset-based (cost) approaches.
- In reaching a conclusion about the value, the analyst must correlate, reconcile, and assess the reliability of the various value indications and determine whether the value conclusion should be based on a single valuation method or a combination of valuation methods.
[Source: Chiovari, Cory R., and Robert F. Reilly, “The Financial Adviser and the AICPA Statement on Standards for Valuation Services,” Insights (Winter 2008)].
The American Society of Appraiser’s Business Valuation Standards are similar, saying:
“The appraiser shall select and apply appropriate valuation approaches, methods and procedures. The conclusion of value reached by the appraiser will be based on value indications resulting from one or more methods performed under one or more appraisal approaches. The selection and reliance on appropriate methods and procedures depends on the judgment of the appraiser and not on any prescribed formula. One or more approaches may not be relevant to a particular situation, and more than one method under an approach may be relevant. The appraiser must use informed judgment when determining the relative weight to be accorded to indications of value reached on the basis of various methods, or whether the indication of value from a single method should be conclusive” [Source: American Society of Appraisers Business Valuation Standards BVS-I IV A, BVS-VI II B, III A & B, 2008].
The implementation guidance for SFAS 157 provides two examples of the use of multiple valuation techniques. They illustrate some of the factors that must be considered in determining fair value. Some key points are:
- When using multiple valuation techniques the goal is to determine the point within a range that is most representative of fair value in the circumstances.
- Sufficient data must be available to apply the valuation approach.
- A particular approach may not be appropriate to a specific fair value measurement.
- The fair value indicated by a particular approach will fall into a range.
- The relative weight ascribed to an approach depends on the relative reliability of the inputs.
- The number and subjectivity of the adjustments to inputs determines their relative reliability.
- The degree to which the ranges overlap should be evaluated.
- The reasonableness of the ranges must be considered.
- The width of the range and where the majority of data points fall within the range provides information to be considered.
- The attributes of the asset being valued may make the selection of one approach more appropriate to the exclusion of another
[Source: SFAS 157, paragraphs A13–A19].
In the “Background Information and Basis for Conclusion” section of SFAS 157, the FASB emphasized that:
…in many cases, multiple valuation techniques may not be appropriate or cost beneficial . . . Consistent with existing valuation practice, valuation techniques that are appropriate in the circumstances and for which sufficient data are available should be used to measure fair value. The Statement does not specify the valuation technique that should be used in any particular circumstances. Determining the appropriateness of valuation techniques in the circumstances requires judgment. . . . The Board expects that in some cases a single valuation technique will be used. In other cases, multiple valuation techniques will be used, and the results of those techniques evaluated and weighted, as appropriate, in determining fair value. . . . However, in all cases, the objective is to use the valuation technique (or combination of valuation techniques) that is appropriate in the circumstances and for which there are sufficient data [Source: FASB SFAS 157, paragraphs C54–C56].
A final requirement of SFAS 157 relating to valuation techniques used to measure fair value is that the technique must be consistently applied. Paragraph 20 states that “a change in valuation technique or its application would be appropriate when the change results in a measurement that is equally or more representative of fair value in the circumstances”.
Examples of situations when it would be appropriate to change techniques include:
- when new markets develop;
- when new information becomes available;
- when information previously used is no longer available; and
- when valuation techniques improve.
A change in the weighting of multiple valuation techniques would be considered a change in application. Changes in valuation techniques or the application of those techniques shall be accounted for as a change in estimate under FASB Statement No. 154, Accounting Changes and Error Corrections. The disclosure requirements of SFAS 154 are not applicable to changes in valuation techniques because the board did not consider them to be cost-beneficial.