Equipment Appraisal Blog | Understanding Machinery Appraisals

As an accredited or certified machinery and equipment appraiser, you will learn that three approaches to value are considered for every appraisal: The Sales Comparison, Cost, and Income Approaches. Except in rare cases, only the first two are utilized in a typical valuation as business revenue and expenses under an income approach are very difficult and impractical to apply directly to equipment as part of a larger operating facility. Here are a few broad discussion points regarding these two primary approaches.

The Sales Comparison Approach, which is commonly referred to as the “market” approach, focuses on the research and analysis of similar used machinery being bought and sold in the resale marketplace. The appraiser reviews available listings, sales, and databases, while gathering opinions of value from dealers and other resellers, and ultimately adjusts the data to reflect a reasonable opinion of value based on the specific characteristics of the assets being appraised.

The Cost Approach relies on the determination of key variables that pertain to estimating equipment value, including replacement cost new, useful life, effective age, and annual levels of depreciation. Understanding how these factors work in conjunction with each other, as well as providing additional perspective to complement the sales comparison approach, will create a balanced opinion of value.

Both approaches should be considered and relied upon to a certain extent in every equipment appraisal to avoid a limited perspective. The amount of data the appraiser can develop under each approach will determine the level of weight assigned to each. In some cases, the equipment may have a limited amount of used market data and need stronger reliance on a cost approach and vice versa.

It is important to understand where the most reliable sources of data are found under each approach and how to reasonably interpret them. The valuation professional should look to specific market and industry sources that directly relate to the subject assets being valued. The appraiser should also avoid taking every source at 100% face value while creating a “common sense” approach that brings the information together to form a realistic opinion of value.

Keep in mind the conclusions you ultimately estimate are your opinion, and not anyone else’s. You will cite all the sources you relied upon; however, they are individually only one component of the overall appraisal that you develop. The more experience you gain over time will bring these processes into better focus as you continue to understand the nuances of machinery and equipment valuation.

When an appraiser estimates value, they must do so under an assumed premise that relates to the type of transaction being undertaken and the potential outcomes of an impending sale. Premise of value is one of the most critical components of an equipment appraisal given the different assumptions each premise represents and their material differences.

Each value premise must be defined in the appraisal and can reasonably be tied to a typical market transaction, such as a user-to-user sale or an auction liquidation. The most commonly referred to premise is Fair Market Value, which is utilized in many standard business agreements when the need arises to assess value for any purpose. The American Society of Appraisers defines Fair Market Value as follows:

Fair Market Value is an opinion expressed in terms of money, at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts, as of a specific date.

There are variations to the Fair Market Value premise, including assumptions for installation and continued use, which typically drive higher levels of value given the additional considerations involved. The important factor to understand with Fair Market Value is that it represents the most equitable transaction for both parties, where neither the buyer nor seller have an advantage. Each party is equally willing to transact and knowledgeable of all the facts.

In the open resale marketplace, this may not always be the case, therefore, other premises of value are considered, including Orderly and Forced Liquidation. These definitions add the factor of compulsion on behalf of the seller, with more limited time to sell a key factor. These premises are appropriate to consider with an inexperienced owner or if a company goes out of business. There may be a reduced level of control over the sale by utilizing a third party, such as an auctioneer, to liquidate the assets. This is the foundation for Forced Liquidation Value.

Liquidation premises of value are commonly reviewed by banks and other lenders who want to consider the possibility of having to step in and resell the equipment if their borrower defaults and they end up taking possession of the assets. They are not in the business of buying and selling machinery and may involve an equipment dealer or auction company to manage the logistics of a resale effort.

These liquidation premises will obviously drive a lower estimated value for the machinery & equipment. How much lower will depend on the type of equipment and the state of the resale market, among other factors. Consult with an appraiser to better understand these differences.

As a business owner, when you determine it is time to sell off older equipment and upgrade to more recent or even brand-new makes and models, you will need to enter the market and begin to research options to effectively handle the transition. It’s only logical that you will seek to understand both new and used machinery pricing based on what is available from dealer networks and other sellers. Obtaining an independent appraisal of your existing fleet will be very helpful in validating and comparing your thoughts and findings, ensuring your ability to make a fully informed decision.

As part of an equipment appraiser’s analysis, they will research and source comparable market information, while also analyzing available databases and their experience valuing similar assets in the past. Used equipment asking prices and recent sales are important to review during this process, however, it is just as important to understand the new machinery market and gain this additional perspective.

Replacement Cost New is the formal term for what brand new equipment should sell for in the current market, or as of the effective date of valuation. Machinery and Equipment appraisers can utilize this component of their research in several ways when comparing it to the other market data they develop. It is a principal element of the Cost Approach to value.

An appraiser should first determine a reasonable pattern or relationship between the new and used pricing while taking into account the equipment’s age, useful life, and commonality in the resale market. For instance, how does new pricing compare to what was originally paid for the machinery being appraised? What are typical levels of market depreciation on a year-to-year basis from newly purchased to the end of the equipment’s initial life cycle?

A seasoned professional will look to estimate new replacement cost for machinery based on available market information from the manufacturer or representative vendors. Utilizing industry trends from broad indexes and applying them to historic pricing is not nearly as reliable as direct market data and should only be used as a last resort. The same goes for developing estimates of depreciation and useful life. An experienced appraiser should never assume straight-line accounting-type depreciation is applicable in the valuation industry.

Even if an appraiser has a multitude of used comparable sales information to consider, they should not neglect to understand replacement cost new, as well as the other components of the cost approach. This complimentary style of appraisal is more reliable and supportable than relying solely on a single approach.

When you decide it is time to replace your equipment and engage an appraiser to assist in the overall effort, ask about these types of methodologies and approaches to ensure you are working with the most competent professionals.

The next set of blog posts over the coming weeks will discuss the various elements of machinery and equipment appraisals and their potential influence on the overall valuation analysis. This week’s focus is on normal useful life.

Normal useful life is essentially the estimation of how long equipment will last from the time it is new until it needs replacement or a significant rebuild/refurbishment to extend its service. This is typically measured as a specific number, or within a range of years, such as 10 or 8-12 years.

Determining useful life can assist the appraiser when valuing equipment that is still in its initial usage life cycle and provides a broad perspective of the remaining (residual) value, as a percentage of its original or replacement cost. Appraisers can effectively develop depreciation value curves with useful life as a timeline framework while researching and implementing used market data to create points along the curve for estimating fair market and liquidation values, as well as end-of-life salvage value.

Normal useful life should be viewed as a broad-based component of the overall appraisal effort, which provides a reasonable sanity check to the market data and other cost approach variables that go into the analysis. For example, if you have estimated normal useful life at 10 years, and your other research shows that 5-year-old equipment is being marketed for 40-50% of new cost, which could reveal a consistent pattern from both of these perspectives. If, however, the market data for 5-year-old equipment is 60-70% of new pricing, then your useful life assessment may be too low.

Keep in mind normal useful life is merely a benchmark and represents a single life cycle. Appraisers will often see much older equipment available in the used marketplace that has been refurbished or rebuilt during its life which essentially extends or resets the life cycle for these aged assets. The concepts of “effective age” and remaining useful life, come into play when valuing these older machines. For example, a machine originally manufactured 20 years ago with a 10-year initial normal life may “effectively” be much younger and have a number of years of life remaining, given the refurbishment effort.

It's important to estimate normal useful life and remaining life for both newer and older vintage machinery and equipment as part of an appraiser’s overall analysis. Factoring in the market data and other cost approach factors you develop will create a well-researched and supportable valuation.

Image author S zillayali Wikimedia license 

If you’re a business owner who needs capital equipment to run their operation, you have likely debated whether to buy or lease the machinery when it comes time to invest in new assets. Similar to automobile or truck leasing, which is a bit more common in both the personal and commercial trade markets, you will be presented with this option during the transactional phase by the equipment vendor or dealer.

There are primarily two things to consider when deciding whether to lease or purchase your new machinery and equipment.

1. Do you intend to utilize the assets over the long term, maintaining and refurbishing them and maximizing their useful life? If the answer is yes, then you will want to buy the equipment given the lease will likely be a shorter-term transaction (3-5 years) with a fair market value buyout that may compel you to overpay at the end of the lease to retain longer-term.
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3. If you are confident you will want to return the equipment at the end of the lease and look to trade up to another new model and use the equity in the lease to better afford the upgrade, then leasing may be the right answer.
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5. Do you prefer to capitalize machinery on your books, increase your balance sheet and taxable asset base, or treat monthly rental payments as an expense to the operation? If the former is true, then purchasing equipment is the way to go while the latter business tactic will best fit a leasing scenario.
   
   
6. The benefit of purchasing and capitalizing is the depreciation expense allowable each year, and you will also gain equity in your machinery that you can leverage for refinancing or other capital infusion needs down the road. With a lease, the monthly rental expense along with the lack of a higher balance sheet can create an efficient accounting method to maintain steady cash flows and keep debt at a lower volume.

Your business will be responsible for maintenance, insurance, and property taxes, regardless of whether you own or lease the assets, so the determination should hinge on the above two factors to make a sound investment decision. If you return the equipment at lease termination, it will need to be in good operating condition, or you might face penalties on top of the costs to return it. If you decide to lease regardless of your circumstances, try and negotiate a cap at the end-of-term buyout in case you decide to purchase down the road.