In the valuation process, the appraiser must consider all three basic approaches to value, which are:
Cost Approach: This approach is based on the proposition that an informed purchaser would pay no more for a property than the cost of producing a substitute property with the same utility as the subject. It considers that the maximum value of a property to a knowledgeable buyer would be the amount currently required to construct or purchase a new asset of equal utility. When the subject asset is not new, the current cost new for the subject must be adjusted for all forms of depreciation as of the effective date of the appraisal.
In virtually every inventory appraisal, the cost approach is the fundamental cornerstone upon which any alternate conclusions are subsequently expressed. The final inventory value conclusions are most often expressed in percentages and currency, as establishing an appropriate and supportable cost is an essential element in preparing an appraisal report. In many cases, an inventory changes by the day if not by the minute. For this reason, a percentage is the best indicator of value, assuming the mix of quantity, type, or condition does not dramatically change. There are almost as many ways of expressing cost as there are companies trying to expose it. The appraiser must have at least a general understanding of a few key terms, and a comprehensive understanding of how and under what method the subject inventory is maintained. This must be accomplished before the initiation of any sampling or valuation.
Depending on the level-of-trade, there could be direct expenses such as labor and overhead, which should be given proper consideration. If these factors did exist and were not considered as part of the actual unit cost, the value analysis would be developed from a partially burdened cost. This would be improper, as cost should be considered fully either burdened or unburdened. A fully burdened inventory is one in which all appropriate costs have been allocated to individual line items. Therefore, conferring with the proper individual to assess what elements are considered in the subject company’s cost, to arrive at the actual cost of goods sold, is necessary. When a unit cost has been established for each Stock-Keeping-Unit (SKU), the necessary assignment to the ending inventory and cost of goods sold can be accomplished, for which there are several methods. Determination of the method used is important to the appraiser because not only does the appraiser need an understanding of the flow of costs; they also need to understand the actual flow of goods.
Sales Comparison Approach: This approach, also known as the “Market Comparison”, involves the comparison of comparable recent sales (or offerings) of similar assets to the subject. If the comparable sales are not exactly like the subject, adjustments must be made to the price of the comparable sales (or offerings). These adjustments may be either up or down to estimate what the comparable would have sold for if it had the same characteristics as the subject. This approach leads to an indication of the most probable selling price for the assets being appraised.
The Sales Comparison Approach can most readily demonstrate the difference between inventory and other personal property appraisals. For example, if the appraiser were conducting a market value appraisal of a machine shop, the preferred method of determining a value on, say, a Bridgeport Mill would be to find comparable sales of similar mills. These are generally single item comparisons, e.g., sale of the comparables being evaluated occurs one at a time. Meaning, the equipment appraiser would not consider the sale of 1,000 Bridgeport mills between two brokers as evidence of the value of one mill in a machine shop. However, for inventory there is never a true or representable market sale, even within the same industry. This is because the mix of individual part numbers unique and so variegated that no direct linear comparison relative to the overall recovery can be correlated.
Income Approach: This approach considers value in relation to the present worth of future benefit derived from ownership, and is usually measured through the capitalization of a specific level of income. This approach is rarely utilized in the valuation of personal property.
While considering all three approaches to value is requisite to the appraiser, the Income Approach for inventory is rarely relied upon as a final indicator of value. As with any income stream accruing from a group of assets, i.e., plant, property, real estate, inventory, and intangibles, organized into an entity designed to maximize profit, allocation of the net income to individual assets is problematic.
While inventory is the item sold, the percentage of net income attributed to the inventory as its “value” cannot realistically be measured except by application to its basis, i.e., its cost. This leads directly back to the cost approach for financial statements and standard valuation techniques used in business valuations. For example, when an inventory valuation expert is called upon to assist in a business valuation, this individual’s focus is directed toward analyzing the perpetual inventory records to reconcile back to the balance sheet. Therefore, allocation of “value” to the inventory made by the business valuation expert performing a discounted cash flow model is precisely the adjusted cost conclusion made by the inventory expert. However, there are individual cases in which the inventory appraiser will rely heavily, if not exclusively, on the Income Approach in reaching a conclusion of value. This is best illustrated by example.
Consider a subject whose sole occupation is the leasing of welding cylinders. The subject has been in business for more than fifty years, and virtually controls greater than 95% of the cylinder leasing market share in which they reside. The subject rents a single warehouse in which the cylinders are periodically refurbished, and in which replacements are stored. The real estate lease is month-to-month, so there is no leased fee value. The only other tangible assets are a small amount of office equipment, a small fleet of delivery vehicles, and two forklifts. These have been valued at less than $50,000 by a machinery & equipment appraiser.
The cylinder inventories, ranging in age between one and fifty years, have also been valued by the machinery & equipment appraiser using both the Sales Comparison and Cost Approach. The cylinder inventory totals approximately 50,000 units, 90% of which are leased at any given time. Based on comparable sales, the cylinders have been assigned a market value of $100 each, for a total of $5,000,000. Based on appropriate forecasts of economic life, effective age, and remaining useful life, the cylinder inventory has been valued via the cost approach at $85 each, for a total of $4,250,000 [50,000 units X $85 = $4,250,000].
In analyzing the subject’s cash flow history, it is concluded that the subject’s annual net income is $1,250,000, which accrues exclusively from the lease of the cylinder inventory. After a full analysis of all relevant data and development of an appropriate discount model, a discount rate of 12% is concluded. Based on net income, the value conclusion for the cylinder inventory from the income approach is $10,000,000 [$1,250,000 × .12 = $10,000,000].
Clearly, this is an example of a case in which the Income Approach may be the best indicator of value for a rental inventory. In this instance, the intangible value of a captive customer base that produces a net income stream far beyond the standard asset balance sheet to net income ratios will usually produce such a disparity between the income and other approaches to value. The purpose of this demonstration is to show that the inventory appraiser should be sufficiently well versed in Income Approach techniques at least to be able to prove its applicability or inapplicability, if so solicited. It should be pointed out that other items could contribute to the net income, and would have to be identified, quantified, and deducted before the value could be attributed solely to the cylinders. This is almost impossible to accomplish by an appraiser, as it could include customer lists, administrative and management techniques, location, and many other factors.
The law of quantity discounts, and the defining relationships controlling sales between brokers, would combine to preclude the use of this transaction as evidence of value for a single mill. However, the sale, or in the case of purchasing a single inventory item depends solely on the circumstances surrounding the purchase. Here the level of trade concept again reasserts itself as a dominant factor.
Using the mattress example, the distributor buys a shipment of 10,000 units from the manufacturer for $85 each. This would be considered a comparable sale, interchangeable as a term with purchase, but only at the distributor’s level of trade. This would not be a comparable sale, unless properly adjusted, for the same mattress at the retail level of trade, for all of the reasons previously described.
This issue can become further complicated by the intrusion of a standard sales practice such as a quantity discount. If the hypothetical distributor elects to buy 50,000 units instead of 10,000 units, this would decrease their basis to $80 each. Side-by-side in the warehouse, the $80 mattress is indistinguishable from the $85 mattress!
Because of these factors, the best use of the sales comparison approach for inventory is, as a general guideline, a credible range of value reached through the cost approach for a particular mix. Comparable data is usually available for bulk sales, but the problem with any bulk sale is the unknown mix. For example, the appraiser finds, in the investigative stage of the appraisal, that a competitor recently sold several thousand hard drives to a broker for twenty cents on the cost dollar. This seems to be an excellent comparable because the subject and the competitor are both known for high-quality drives. However, when the appraiser informs the subject’s owner of this find, the appraiser is suddenly confronted with a hostile owner who insists the sale is not comparable at all. The owner’s contention is that the competitor “dumped” its obsolete hard drives in a “fire sale”, and contends that the sale should be ignored entirely. Actually, the owner has made an excellent point. In such a bulk sale, the only factor driving bids for such an amalgamation of disparate sizes, speeds, and conditions would be the mix between the good and bad items.
There is usually no manner of evaluating mix in such a comparable sale for use in making a relationship to another inventory. For example, the comparable sale may have included damaged inventory or slow-moving and obsolete drives, while the subject’s inventory, which has been cleared of excess items, has an excellent mix of high-speed current merchandise. Based on the only sales comparable available, extrapolating the sale results to the subject would, nevertheless, be imprudent and inaccurate without compensating for the differences in mix. The opportunity to make such compensatory adjustments is rare.
On the positive side, much nonspecific information can be gleaned from parties to the aforementioned sale. Comments relating to mix can prove invaluable in valuing individual items within the overall mix of the inventory being appraised.
Another way in which comparable sales are important is in measuring the impact of changes in individual factors by isolating a particular factor as the only difference between two otherwise identical transactions. It may be found that two inventories similar in concentration, location, timing, and market conditions were sold under arms-length conditions, but at vastly different percentages of recovery. Further investigation leads to the conclusion that the primary reason for the difference is the relative size of the two transactions. This can provide very specific adjustments, at least in an industry such as this, for differences in quantity sales.
