4.4 Valuation approaches, techniques, and methods (2024)

The market approach is often used as the primary valuation approach for financial assets and liabilities when observable inputs of identical or comparable instruments are available. ASC 820-10-55-3A through ASC 820-10-55-3B defines the market approach.

The market approach is also used commonly for real estate when comparable transactions and prices are available, and can be used to value a business or elements of equity (e.g., NCI). The market approach may also be used as a secondary approach to evaluate and support the conclusions derived using an income approach.

Matrix pricing is a valuation technique within the market approach. It is a mathematical technique that may be used to value debt securities by relying on the securities’ relationship to other benchmark quoted prices and is commonly used to price bonds, most notably corporate and municipal bonds.

The cost approach assumes that the fair value would not exceed what it would cost a market participant to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. ASC 820-10-55-3D defines the cost approach.

This approach assumes that a market participant buyer would not pay more for an asset than the amount for which it could replace the service capacity of that asset. Obsolescence includes “physical deterioration, functional (technological) obsolescence, and economic (external) obsolescence.” Therefore, in using a replacement cost approach, a reporting entity would need to consider the impact of product improvements.

The cost approach is typically used to value assets that can be easily replaced, such as property, plant, and equipment.

The income approach is applied using the valuation technique of a discounted cash flow (DCF) analysis, which requires (1) estimating future cash flows for a certain discrete projection period; (2) estimating the terminal value, if appropriate; and (3) discounting those amounts to present value at a rate of return that considers the relative risk of the cash flows and the time value of money. Terminal value represents the present value at the end of the discrete projection period of all subsequent cash flows to the end of the life of the asset or into perpetuity if the asset has an indefinite life.

Income approaches are used to measure the value of liabilities, intangible assets, businesses (e.g., for purposes of computing an internal rate of return, or to measure the fair value of an NCI or previously held equity interest when the price is not observable), and financial instruments when those assets are not traded in an active market.

ASC 820-10-55-4 discusses the use of present value techniques in the determination of fair value. Those techniques include the “discount rate adjustment” technique and the “expected cash flow (expected present value)” technique.

ASC 820 neither prescribes the use of one single specific present value technique nor limits the use of specific present value techniques to measure fair value, instead indicating that a reporting entity should use the appropriate technique based on facts and circ*mstances specific to the asset or liability being measured and the market in which they are transacted, and with all valuation techniques, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.

ASC 820-10-55-5 indicates that the following key elements from the perspective of market participants should be captured in developing a fair value measurement using present value:

ASC 820-10-55-6 also discusses general principles that govern the application of all present value techniques.

In practice, adjusting the expected cash flows to reflect systematic risk is often difficult. In most instances, therefore, for nonfinancial assets, the discount rate that is applied to cash flows incorporates systematic or non-diversifiable risk, which is often represented by a weighted-average cost of capital that would be required by a marketplace participant. However, adjustments made to the discount rate tend to underweight risk. Additionally, the discount rate is a single point estimate, while expected cash flows are weighted by different probabilities of occurrence in the future.

Figure FV 4-1 highlights common valuation techniques within each of the valuation approaches.

Figure FV 4-1
Valuation approaches and techniques

The selection of appropriate valuation techniques may be affected by the availability of relevant inputs and the relative reliability of the inputs, or by the type of asset or liability being valued. In some cases, one valuation technique may provide the best indication of fair value (e.g., the use of the market approach in the valuation of an actively traded equity security); however, in other circ*mstances, multiple valuation techniques may be appropriate (e.g., in valuing a reporting unit or cash-generating unit for purposes of step 1 of a goodwill impairment test).

The application of each technique may indicate different estimates of fair value. These estimates may not be equally representative of the fair value due to the assumptions made in the valuation or the quality of inputs used. Using multiple valuation techniques can act as a check on these assumptions and inputs. The reporting entity should carefully evaluate the inputs and assumptions used if the range of values is wide. Fair value should be based on the most representative point within the range considering the specific circ*mstances.

As discussed in ASC 820-10-35-25 through ASC 820-10-35-26, reporting entities should consistently apply the valuation techniques used to measure fair value for a particular type of asset or liability. However, it is appropriate to change a valuation technique or an adjustment that is applied to a valuation technique if the change will result in a measurement that better represents fair value; for instance, a change in a particular technique’s weighting when multiple valuation techniques are used may be appropriate based on changes in facts and circ*mstances. A change in valuation technique may also be warranted as new markets develop, new information becomes available, information previously used is no longer available, valuation techniques improve, or market conditions change. Revised valuations resulting from a change in the valuation technique or its application are accounted for as a change in accounting estimate, with the change impacting the current and future periods, if applicable.