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.

Machinery and Equipment is perhaps the least understood type of property when it comes to appraisal approaches when compared with Real Estate and Business Valuation. This may be because, in large part, real property, such as buildings, land, and improvements, are commonly viewed as higher value, non-depreciating assets, while overall business appraisal considers the sum of everything a company has to offer in an investment or lending scenario.

When considering the three industry-accepted appraisal methods, Cost, Sales Comparison (Market), and Income approaches, machinery valuation will almost exclusively rely on the first two, while real estate and businesses commonly use the income approach as well.

There are a couple of primary reasons why this is the case. Historic and discounted future cash flows considered and utilized under the Income Approach can often be directly tied and measured with buildings and land in the form of rental and lease revenue, while a business appraisal is in large part determined by the internal financial performance of the company.

Machinery, along with other types of personal property, are considered support assets required to be utilized as a part of a larger working operation. Therefore it is impossible and impractical to try and allocate a portion of any type of business revenue to the equipment itself. Even if machinery is the primary asset involved with the business, there are many other factors to consider in the overall company performance which directly or indirectly drive revenue. To try and allocate all or a part of these cash flows to it would be unfeasible.

Equipment value can be directly measured under the cost and market approaches by researching what new and used equipment sells for in the marketplace while applying reasonable factors for normal useful life and annual levels of depreciation. Regardless of how often the machinery operates or how integral it is to the day-to-day operation of the business, the value of these types of assets is driven by what an unrelated third party would consider paying for them, whether in its current operation or for another future use. What it costs to purchase and install these assets, new or used, in the marketplace, along with a review of maintenance history and current condition, are the driving variables behind what someone would pay for them, which ultimately translates to value.

If you are going to attempt to use the income approach to appraise equipment, make sure you have solid evidence that the cash flows are directly related to the machinery itself, and ensure that you are basing the analysis under a “highest and best use” perspective which takes into account the asset’s full potential to generate revenue. The income approach has its place in the appraisal industry, and in many cases with businesses and real estate, will be a primary factor in determining what they’re worth, however, for machinery, equipment, and other types of personal property, as a general rule, stick to the cost and market approaches to measuring these assets' true value.

For machinery & equipment (M&E) appraisers, there are basically two approaches to value that are ultimately relied upon when completing valuations: the Sales Comparison Approach and the Cost Approach.

Here is a brief description of each:

The Sales Comparison Approach

The Sales Comparison Approach indicates value by analyzing recent sales (or offering prices) of properties that are similar (i.e., comparable) to the subject property. If the comparable data is not identical to the properties being appraised, the selling prices of the comparable items are adjusted to equate them to the characteristics of the properties being appraised.

The reliability of this technique is dependent upon the degree of comparability of each property with the property under appraisal; the time of the sale; the verification of the sale data; and the absence of unusual conditions affecting the sale. This approach focuses on the actions of actual buyers and sellers.

The Cost Approach

The logic behind the Cost Approach is the Principle of Substitution: a prudent buyer will not pay more for a property than the cost of acquiring a substitute property of an equivalent utility.

Using the Cost Approach, the appraiser starts with the current Replacement Cost New of the property being appraised and then deducts for the loss in value caused by physical deterioration, functional obsolescence, and economic obsolescence.

The third approach to value, the Income Approach, is rarely used for M&E appraisals, and I will leave that discussion for another time. The Sales Comparison Approach is also commonly referred to as the “Market Approach”, however, don’t let that trick you into thinking the only time you rely on market data is under this approach. To effectively use the Cost Approach, an appraiser should rely on the marketplace as well, to estimate the variables involved with this approach, including replacement cost new, useful life, depreciation, and salvage value.

Perspective From Both Approaches

Every appraiser has their own process as to how they ultimately utilize the tools available to determine value. It is ultimately an independent, unbiased, subjective opinion, based on the gathering of a reasonable amount of data, which is developed during a research and analysis process.

To that end, from my experience, I have found it beneficial to take components from both approaches, established directly from the marketplace, and create a dual perspective that ultimately forms credibility checks to both, and provides the appraiser with supportable conclusions. Given that comparable sales data can tend to be inconsistent from machine to machine, even from the same sources, this blended approach can create a way to make sense of all the data points and better understand how particular assets should depreciate in the marketplace under normal maintenance and wear and tear guidelines. The use of the Cost Approach in any other way, such as using straight-line depreciation to cover all forms, or trying to develop credible levels of replacement cost and obsolescence by using broad industry data, is simply not reliable or supportable.

In summary, regardless of how much weight an equipment appraiser places on either of these two approaches during a valuation analysis, they should assure their clients that the data collected comes directly from the marketplace. The independent sources that an accredited M&E appraiser can find for virtually any type of asset are out there and available, they just need to do a bit of digging to find them