Market, cost and income approaches

Learning objectives

• Distinguish the market approach, the cost approach and the income approach, and the type of inputs each uses.L2

Normative references

• IFRS 13Appendix A: definitions of the terms used in the Standard (active market, cost approach, entry price, exit price, expected cash flow, fair value, highest and best use, income approach, inputs, Level 1 to Level 3 inputs, market approach, market-corroborated inputs, market participants, most advantageous market, non-performance risk, observable inputs, orderly transaction, principal market, risk premium, transaction costs, transport costs, unit of account, unobservable inputs). Market participants are defined as independent, knowledgeable, able and willing to enter into a transaction.
• IFRS 13 §B1The judgements applied may differ depending on the valuation situation; Appendix B describes those judgements.
• IFRS 13 §B5Market approach: uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or groups (for example a business).
• IFRS 13 §B6The market approach often uses market multiples derived from a set of comparables; selecting the appropriate multiple within the range requires judgement.
• IFRS 13 §B7Matrix pricing, used mainly for some debt securities, is a technique consistent with the market approach.
• IFRS 13 §B8Cost approach: the amount that would be required currently to replace the service capacity of an asset (current replacement cost).
• IFRS 13 §B9From the perspective of a seller, the price is based on the cost to a buyer of acquiring or constructing a substitute asset of comparable utility, adjusted for obsolescence (physical, functional, economic), a broader notion than depreciation for financial reporting or tax purposes.
• IFRS 13 §B10Income approach: converts future amounts (cash flows, income, expenses) to a single discounted amount that reflects current market expectations.
• IFRS 13 §B11Examples of income approach techniques: present value techniques, option pricing models, the multi-period excess earnings method (certain intangible assets).

Original summaries of the paragraphs (reference register), never a quotation of the standard.

3 questions

• Valtrin estimates the fair value of an interest in an unlisted company by applying to its earnings the multiples observed in recent sales of comparable companies. Which valuation approach does this correspond to?L2
• For a highly specialised machine, a valuer estimates what it would cost today to replace its service capacity, then allows for the wear and obsolescence of the unit being valued. Which approach is being applied?L2
• Which of the following statements about the income approach are correct?L2