How to Appraise the Machinery of Continuous Processing Plants
Date December 2013
The appraisal of machinery and equipment and other fixed assets often relies on commonly applied, and industry-accepted, approaches to value — in particular, the cost and/or the market approaches to value. In certain situations, a client might seek additional information, evidence and support to verify that the cost and market approaches produce reliable and accurate values. In addition, the client might be concerned that certain company-specific situations or industry trends might not be completely reflected or considered in the cost or market approaches.
In these instances, a "business overlay" can be an invaluable approach to consider. This approach will provide evidence that company-specific and industry trends are fully considered in the ultimate valuation conclusions.
The concept of a business overlay is derived from the relationship of the value of a business enterprise, also known as invested capital, and its underlying components. The components of a business are depicted here.
The business overlay approach to value considers the overall cash flows and value of a company as a whole. An income approach, or cash flow approach, is a common method to value entire companies. The value of company assets that are known, such as working capital and real, are subtracted from the company value to derive a value available to the remaining assets. The residual value essentially determines whether the residual assets are providing an adequate return for the company. If they aren't, then an economic obsolescence exists.
A simplified example of this calculation is:
Overall value of the operating business enterprise (invested capital or all assets)
Less: working capital
Less: fair market value in use of the real estate
Less: fair market value of identified intangible assets
Less: fair market value of any other non-M&E asset contributing to the operating business value
Equals: overall fair market value in use of machinery and equipment
In general, the fair market value in continued use needs to be supported by the going concern earnings capacity of the business that the machinery and equipment supports.
In deriving the residual value (or available return on) the remaining assets, an appraiser will consider all information available concerning the company, its assets and industry trends affecting the company's cash generation ability. For example, the appraiser will request that management provide a detailed financial projection. The appraiser will review the projection and analyze factors such as growth rates, margins, competition, and customer retention and new customer generation. In addition, an industry-based discount rate is developed to consider various risk factors within the industry, as well as company-specific risks.
This detailed business analysis results in some portion of the overall enterprise value of the business being attributed to the subject machinery and equipment. An appraiser will work with the client to estimate the amount of intangible value associated with the overall enterprise value. In many situations, the intangible asset value is considered to be immaterial, or is a very small percentage of the overall value and generally can be fairly easily estimated. This valuation approach combines the knowledge of the productive capacity of the assets with the knowledge of the profitability aspects of the products it produces, in the current competitive environment.
For example, many manufacturing operations have highly specialized and/or installation-intensive machinery. If these assets are sold piecemeal for removal, then the proceeds realized, in relationship to their original installed cost new, can be pennies on dollar. Conversely, plants of this type can be very desirable if the machinery is purchased to remain in-place and in-operation, making the products for which the equipment was originally intended. In these cases, it's meaningful for asset-based lenders to consider a business valuation overlay in contrast to auction and/or orderly liquidation value appraisals. Examples of plants where it might be relevant to consider a business valuation overlay include chemical plants, pulp/paper mills, steel mills and breweries, to name a few.
By performing a business valuation overlay simultaneously with the traditional cost and market approaches to value, it's possible to determine the amount of value attributable to all classes of assets (working capital, fixed assets and intangible assets) within the framework of the entire enterprise. This ultimate value conclusion is representative of all physical depreciation and functional and economic obsolescence affecting the value of the equipment, quantified through the valuation of the business enterprise as well as traditional cost and market approaches to value.