Valuing Machinery and Equipment

Approaches, Standards, and Terms

Although machinery and equipment appraisals differ from business valuations as a distinct branch of the appraisal practice, many overlapping concepts reinforce and support the key factors needed to establish a reliable and defensible opinion of value for the subject assets. This article provides a primer on the subject matter.

 

“In the world of valuation, the most important element is to understand what drives value.”

Bruce Greenwald (economist and professor)

Although machinery and equipment appraisals differ from business valuations as a distinct branch of the appraisal practice, many overlapping concepts reinforce and support the key factors needed to establish a reliable and defensible opinion of value for the subject assets. When dealing with machinery and equipment, accurate appraisals are vital in numerous situations, including: (1) when someone is buying or selling used machinery and/or equipment; (2) lenders often require appraisals to confirm the equipment’s value before providing financing, or when using it as collateral; (3) insurance companies may need appraisals to determine appropriate coverage levels or to settle claims; (4) accurate valuations can also impact tax assessments, affecting property taxes or charitable donations. In business mergers or acquisitions, appraisals ensure the equipment’s value is correctly reflected on the balance sheet. Additionally, appraisals can serve as crucial evidence in legal disputes such as estate settlements, divorces, or partnership dissolutions.

Much like business valuations, determining the value of machinery and equipment involves arriving at a well-supported, defensible estimate of worth for capital equipment. Generally, capital equipment is defined as machinery or equipment with a cost of at least $2,500. The appraisal process typically starts with an initial inspection of the equipment, followed by research into market trends, analysis of comparable sales, cost drivers, and other factors influencing the value of the subject assets.

When appraising machinery and equipment, there are several key definitions of value used, including: fair market value, fair market value removed, fair market value in continued use, fair market value installed, forced liquidation value, liquidation value in place, and orderly liquidation value.

• Fair market value refers to the estimated price at which a subject asset would change hands between a willing buyer and a willing seller, with neither party being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts as of a specific date.
• Fair market value installed is the estimated price for which an asset would change hands under the same conditions but taking into account the market conditions for the asset being valued, independent of any income generated by the business where the asset is or will be installed.
• Fair market value in continued use considers the asset’s value based on its continued use in a business, if the earnings support the reported value without further verification.
• Fair market value removed estimates the price considering the asset’s removal to another location, under the same conditions of a willing buyer and seller, as of a specific date.
• Liquidation value in place is the estimated gross amount that could typically be realized from a transaction for a failed, non-operating facility, assuming the entire facility is sold intact under a situation where the seller is compelled to sell.
• Orderly liquidation value is the estimated gross amount that could typically be realized from a liquidation sale, given a reasonable amount of time to find a buyer, with the seller being compelled to sell on an as-is, where-is basis as of a specific date. Various constraints, such as time limits, marketing strategies, location considerations, and prior preparations may influence orderly liquidation value.
• Forced liquidation value represents the gross amount that could typically be realized from a public auction, where the seller is compelled to sell immediately on an as-is, where-is basis. Forced liquidations are subject to similar constraints as orderly liquidation values, with the added condition that the sale must occur within a specific time frame.

Each appraisal user requires a value that aligns with their business context, and the definition of value must be tailored to meet their specific needs. Furthermore, the concept of “highest and best use” is a fundamental principle in valuation and applies to machinery and equipment appraisals. The highest and best use refers to the most profitable legal use of an asset, given its characteristics, location, and market conditions. In the context of machinery and equipment appraisals, the highest and best use concept is crucial for determining the value of an asset based on its optimal utilization.

When evaluating the condition of the machinery or equipment in question, an appraiser would want to determine whether the machine is functioning correctly, if any significant repairs have been recently completed, whether it has a regular maintenance schedule, and if any updates or upgrades have been made. Additionally, they would be interested in knowing if there are any special features, accessories, or added functionalities and whether the owner can provide maintenance records for review. When determining the value of heavy equipment, appraisers consider various factors that can significantly impact the estimate; they include:

• Age and condition: The equipment’s manufacture date and current condition are critical value indicators. Typically, as heavy equipment ages, its value decreases due to wear and tear.
• Make and model: Certain brands and models are more likely to retain value due to their reputation for reliability and performance.
• Hours of use: Like mileage on a vehicle, the number of hours the equipment has been in use affects its value, with more hours indicating greater wear.
• Maintenance history: Well-maintained machinery generally holds higher value. Detailed maintenance, repairs, and replacement records can support a higher appraisal in certain circumstances.
• Market demand: The demand for specific types of heavy equipment can vary, influencing their resale value. High demand typically leads to higher values.
• Technological advancement: Equipment featuring the latest technology or meeting current emissions standards may be more valuable.
• Size and versatility: Larger, versatile equipment capable of performing multiple tasks may retain its value better than single-purpose machinery.

There are three traditional valuation approaches that can be used to determine the value of machinery and equipment assets: (i) the income approach, (ii) the market approach, and (iii) the cost approach.

The International Glossary of Business Valuation Terms defines the cost approach as “a general method for determining the value of an individual asset by estimating the amount of money needed to replace its future service capability.” The first aspect of the cost approach definition focuses on replacement cost in terms of functionality (the ability to perform a task) and utility (the ability to provide satisfaction). The second aspect involves the principle of substitution, which means a seller cannot expect to receive a price higher than a buyer’s willingness to pay. The third aspect addresses obsolescence.

According to FASB ASC 820-10-55, the cost approach considers three main types of obsolescence or depreciation: physical, functional, and economic.

Physical depreciation refers to the reduction in an asset’s value due to its age or wear and tear. Functional depreciation occurs when an asset can no longer perform its intended function, such as when technological advancements render it outdated. Economic depreciation, on the other hand, results from external factors that reduce the asset’s ability to generate a sufficient return, such as a declining industry, loss of resources, or increased competition. Economic obsolescence is often considered incurable.

While the cost approach does not directly assess expected future benefits, it operates on the assumption that future economic benefits will justify the investment’s cost. Under the cost approach, value is determined by the formula: cost + freight + installation – depreciation = value. The NEBB Institute recommends considering the cost approach first, as it establishes the upper limit of value. This approach is particularly useful when the asset can be easily replaced, and the replacement costs are reasonably estimable.

When applying the cost approach, an analyst should prioritize the effective age of the machinery or equipment over the actual age since machines can often be rebuilt or refurbished. As a reasonableness or a sanity check, the general “rule of thumb” suggests that “an item that is in place and functioning is typically valued at 50% to 60% of its newly installed cost.”

In the market approach, the appraiser researches and examines items that have sold or are listed for sale to find comparable assets. This involves investigating relevant markets and may also include statistical analysis to quantify depreciation within an industry or specific type of equipment. To estimate value, the appraiser typically needs information on the asset’s make, model, condition, type, and manufacturer. The market approach provides a value estimate based on prices paid in actual market transactions and current listings, using a process of correlating and analyzing similar recently sold assets. The reliability of this approach depends on how closely the subject asset compares to others that have been sold or are listed for sale, the timing of the transaction, and any special conditions. The market approach offers concrete market transaction data and strong empirical evidence of value.

The best practice is to compare the cost approach indication of value to market data to evaluate the reasonableness and reconcile any potential differences in assumptions and other factors.

The income approach to valuation is based on the present value of the future benefits of ownership. However, this approach is rarely used for appraising individual pieces of equipment because it is challenging, if not impossible, to identify specific income streams for each item. As a result, the income approach may be considered inappropriate for machinery and equipment appraisal assignments. However, the income approach can be relevant in some instances, particularly when appraising heavy equipment tied to rental or lease agreements that produce a steady income stream.

The appraisal process generally follows a similar structure across different types of appraisal assignments. This includes initial intake and discussions with the client, confirming the existence and inspecting the subject assets, identifying and assessing their condition, entering and refining data, conducting market research, performing cost analysis, determining value, and writing the report. What varies between assignments is the level of detail, scope, intended use, and other specific requirements needed to meet the objectives of each engagement.

As Howard Marks, the investor and co-founder of Oaktree Capital Management, once said, “You can’t predict, but you can prepare.” Appraising machinery and equipment requires a deep understanding of both the tangible aspects of the assets and the market conditions in which they operate. It is not just about assessing physical condition; it is also about evaluating functionality, technological relevance, and the economic environment to determine a true and accurate value estimate.

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Nataliya Kalava, CVA, ABV, MAFF, CMEA, is an expert in the fields of business valuation and finance, with about 15 years of experience. She has led and contributed to numerous valuations for diverse purposes, including gift and estate tax planning, management planning, M&A transactions, SBA valuations, financial reporting, and litigation support. Ms. Kalava’s passion lies in helping business owners navigate ownership transitions, guiding them through challenges, and uncovering opportunities for growth. Her expertise is honed through a rich career journey, having worked with renowned organizations such as Equinix Inc., Humana Inc., BDO LLP, Sigma Valuation Consulting Inc., and PwC. Ms. Kalava’s dedication to her profession extends to education and community engagement. She has been an Adjunct Finance faculty member at the University of Tampa, imparting her knowledge to undergraduate students on corporate finance and investment. Furthermore, she organizes Continuing Legal Education (CLE) courses on business valuation topics accredited by the Florida Bar.

Ms. Kalava can be contacted at (813) 999-1144 or by e-mail to nkalava@one10firm.com.