The three widely used valuation techniques cited by IFRS 13 are:
Entities should choose a technique, or combination of techniques, that is most appropriate in the circumstances and for which sufficient data are available to measure fair value. In doing so, entities should maximise the use of relevant observable inputs and minimise the use of unobservable inputs (IFRS 13.61-63).
The market approach uses prices and other relevant information generated by market transactions involving identical or similar assets and liabilities. Valuation techniques based on market approach often use market multiples derived for certain variables. For example, businesses are often valued based on their revenue or EBITDA multiples. Matrix pricing is another example given by IFRS 13, where fair value of certain financial instruments (usually bonds) is measured by interpolating values for similar instruments (e.g. similar credit rating of the issuer, maturity etc.) arranged in a matrix format (IFRS 13.B5-B7).
Market approach is usually used for the measurement of:
- cash generating units and businesses (by reference to quoted prices or transactions in the same industry and based on revenue/EBITDA/other multiples),
- properties (by reference to transactions for similar properties).
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The cost approach, often referred to as a current replacement cost, aims to reflect the amount that would be currently required to replace the service capacity of an asset adjusted for obsolescence (e.g. physical deterioration, technological or economic obsolescence). This valuation technique assumes that a market participant would not pay more for an asset than the amount for which it could obtain the service capacity of that asset elsewhere.
Cost approach is usually used for measurement of:
- tangible assets that are developed internally or
- assets that are used in combination with other assets and liabilities (IFRS 13.B8-B9).
Example: Current replacement cost of specialised equipment
On 1 January 20X1, Entity A acquired a specialised piece of equipment for $1 million. On 31 December 20X4, Entity A was acquired by Entity X and Entity X must recognise this equipment at fair value under IFRS 3 requirements. The equipment was heavily tailored for the needs of Entity A and there is no identical or even very similar equipment available ‘off the shelf’. In order to overcome this obstacle, Entity X obtains price lists of pieces of equipment similar to that held by Entity A at 1 January 20X1 and 31 December 20X4 and determines that they have risen by 20% during that period. Entity X determines that this is the reasonable approximation of an increase in price that would have to be paid to obtain the tailored equipment held by Entity A. Therefore, the replacement cost of a new piece of identical equipment is determined to be $1.2 million. This however is not equal to the fair value as at 31 December 20X4, as it has to adjusted to take obsolescence into account. Field experts working at Entity A determined that the equipment should be valued at 70% of the new equivalent. Therefore, the fair value is determined to be $0.84 million ($1.2 m x 70%).
Overview of income approach
The income approach converts future amounts (e.g. cash flows or income and expenses) to a single discounted amount taking into account, inter alia, risk and uncertainty (see IFRS 13.B15-B17). When the income approach is used, the fair value measurement reflects current market expectations about those future amounts. Examples of valuations techniques consistent with income approach given by IFRS 13 include present value techniques, option pricing models and the multi-period excess earnings method (IFRS 13.B10-B11).
Present value techniques
Overview of present value techniques
Present value techniques are covered relatively extensively in application guidance to IFRS 13 (IFRS 13.B12-B30). IFRS 13 focuses on discount rate adjustment technique and expected cash flow technique, but this does not limit the use of other techniques (IFRS 13.B12). In general, present value techniques discount estimated future cash flows to a present amount using an appropriate discount rate. Paragraph IFRS 13.B13 lists elements that a present value technique should incorporate whereas general principles can be found in IFRS 13.B14.
Discount rate adjustment technique and expected cash flow technique covered by IFRS 13 differ in how they adjust for risk and in the type of cash flows they use. See more discussion in paragraphs IFRS 13.B15-B17.
Present value techniques are usually used for measurement of:
- cash generating units and businesses (based on estimated revenue and expenses),
- financial assets/liabilities when quoted prices are not available for identical or similar items (based on contractual and/or estimated cash flows),
- investment properties (based estimated rental revenue and operating expenses).
Discount rate adjustment technique
The discount rate adjustment technique uses a single set of cash flows from the range of possible estimated amounts, whether contractual/ promised or most likely cash flows. These cash flows are then discounted using an observed or estimated market rate of return (WACC is used most often). All the risk is therefore reflected in the discount rate. See more discussion and a simple example contained in paragraphs IFRS 13.B18-B22. Discount rate adjustment technique is used much more often than the expected present value technique covered below.
Expected present value technique
Expected present value technique is built on an expected value that is widely used is statistics. It starts with a number of possible future cash flows with assigned probabilities that make up a single amount being the probability-weighted average. See more discussion in paragraphs IFRS 13.B23-B24.
IFRS 13 distinguishes two methods of executing the expected value technique (see IFRS 13.B25-B30), however this distinction is overkill in my opinion and I cannot imagine Method 1 to be common in practice. Therefore, when expected present value technique is referred on this website, it is Method 2 as specified by IFRS 13. The difference between the expected present value technique and the discount rate adjustment technique boils down to the treatment of uncertainty of the cash flows as illustrated below.
Example: Difference between discount rate adjustment technique and expected present value technique
Assume that expectations about cash flows from a financial asset in one year time are as follows, risk-free interest rate is 5% and market risk premium is 3% (IFRS 13.B27):
|Possible cash flows||Probability|
The fair value measurement using the two techniques is as follows:
|Technique||Expected present |
|Cash flows||$780 (1)||$800 (2)|
|Discount rate breakdown:|
|Market risk premium||3%||3%|
|Premium for the uncertainty of the cash flows||n/a (3)||2.80%|
(1) Probability-weighted cash flows.
(2) Most likely cash flows.
(3) Already included in the probability-weighted cash flows.
Multi-period excess earnings method
Multi-period excess earnings method is acknowledged by IFRS 13 as a method to measure the fair value of an intangible asset. It is because that valuation technique specifically takes into account the contribution of any complementary assets and the associated liabilities in the group in which such an intangible asset would be used (IFRS 13.B3(d); B11(c)). Some indirect references to this method are also made in basis for conclusions to IFRS 3 (IFRS 3.BC177), where it is described as a valuation technique where ‘a contributory asset charge is required to isolate the cash flows generated by the intangible asset being valued from the contribution to those cash flows made by other assets. The contributory asset charges are described as hypothetical ‘rental’ charges for the use of those other contributing assets’.
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Multi-period excess earnings method is usually used for measurement of intangible assets that are not readily obtainable by other entities (e.g. customer base – see example below).
Entity AC is a company providing cable TV to its customers. On 1 January 20X1, it acquires Entity TC – one of its local competitors. TC had 100,000 customers on acquisition date. Acquisition accounting requires AC to recognise the acquired customer base at fair value separately from goodwill. Therefore, AC prepared a valuation using multi-period excess earnings method that is presented below. I highly recommend that you see the calculations in an excel file available for download. You can scroll the table below horizontally if it doesn’t fit your screen.
Cash flow projections for the customer base and customer relationship:
|Customer care costs||200.0||193.3||183.3||177.3||166.7||160.0|
|Allocation of |
|Profit before tax||294.0||284.2||269.5||260.7||245.0||235.2|
|Hypothetical tax at 20%||58.8||56.8||53.9||52.1||49.0||47.0|
|Cash flow after tax||235.2||227.4||215.6||208.5||196.0||188.2|
(1) The terminal year represents cash flow projection beyond the period covered by the forecast. Usually, it is equal or close to the last year covered by the forecast.
(2) Revenue is declining as customers switch to competitors, no new customers are taken into account as this valuation relates to customer base at acquisition date only.
Other inputs to the valuation are:
- Post-tax discount rate at 7% (e.g. WACC) and
- PGR (perpetuity growth rate) at -4.36% – estimated growth rate beyond period covered by cash flow projections (it will always be negative for customer base – see the comment for revenue under the table above).
The calculation gives a total fair value of $2,231 m, which can be split as follows:
- $924m: present value of cash flows for years 20X1 to 20X5, and
- $1,307m: present value of terminal year.
As said above, all calculations are available in an excel file.
Relief from royalty method
Relief from royalty method is used for valuations of assets that are subject to licensing, such as brands or patents. Under this method, the fair value of such an asset is calculated as a present value of royalties that would have to be paid to the hypothetical owner of the patent/brand.
Inputs to valuation techniques
Valuation techniques used to measure fair value shall maximise the use of relevant observable inputs and minimise the use of unobservable inputs (IFRS 13.67). Inputs should be consistent with the characteristics of an item being measured that market participants would take into account in a transaction for the item. When there is no quoted price available, an adjustment to a valuation technique may be needed to reflect the characteristics of an item being measured (IFRS 13.69).
Examples of markets in which inputs might be observable include foreign exchange markets, dealer markets, brokered markets and, much less often, principal-to-principal markets (IFRS 13.B34).
Premiums or discounts
Premium or discounts can be taken into account when measuring fair value if they are consistent with the unit of account and would be taken into account by market participants. For example, control premium for a controlling stake in a unlisted subsidiary can be taken into account, i.e. the fair value of a an investment in a subsidiary is greater than the fair value of individual assets and liabilities (IFRS 13.69). There is however as specific ‘PxQ‘ prescription for subsidiaries listed in an active market.
Premiums or discounts that reflect the size of entity’s holding rather than a characteristic of the asset or liability being measured are not permitted in fair value calculation. Specifically, a blockage factor is not allowed to be taken into account (IFRS 13.69;80). Blockage factor is an adjustment to the quoted price of an asset or a liability to reflect the fact that market’s normal daily trading volume is not sufficient to absorb the quantity of instruments held by the entity.
Bid and ask prices
If an asset or a liability measured at fair value has a bid price and an ask price, IFRS 13 permits to use (IFRS 13.70-71):
- price within the bid-ask spread,
- bid prices for assets and ask prices for liabilities,
- mid-market pricing or other pricing conventions that are used by market participants.
When a fair value at initial recognition equals the transaction price and subsequent fair valuation uses unobservable inputs, the valuation technique should be calibrated so that the result of the valuation technique equals the transaction price at initial recognition. This is a way of validating the valuation technique and is discussed further in paragraph IFRS 13.64.
Changes to valuation techniques
Valuation techniques used to measure fair value of an item should be applied consistently. A change in a valuation technique or its application can be made if it results in a measurement that is equally or more representative of fair value in the circumstances. Paragraph IFRS 13.65 gives examples of events that may warrant a change in a valuation technique or its application.
Change in a valuation technique or its application is accounted for as a change in accounting estimate, i.e. prospectively (IFRS 13.66). However, IAS 8 disclosures do not apply as IFRS 13 has its own disclosure requirements in this respect (IFRS 13.93(d)).
Use of multiple valuation techniques
IFRS 13 notes that there will be cases where multiple valuation techniques will be appropriate to measure fair value. In such cases, it is likely that different valuation techniques will yield different results and fair value measurement should be the point within that range that is most representative of fair value in the circumstances (IFRS 13.63). A wide range of fair value measurements may be an indication that further analysis is needed (IFRS 13.B40). Examples 4 and 5 accompanying IFRS 13 illustrate the use of multiple valuation techniques.
International valuation standards
The International Valuation Standards Council (IVSC), an independent organisation, publishes International Valuation Standards (IVS) that can used as a best practice when preparing a valuation. They are gaining in popularity and recognition among valuation experts.
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