Fixed Asset Valuation for Chain Stores: The Importance of Making the Right Assumptions
There is a reason for the adage about assumptions: going off the wrong idea or information could lead to serious trouble. This is particularly true when it comes to the valuation of your business and its fixed assets.
While in any valuation analysis it is important that the selected methodology and the assumptions relied upon are appropriate, retail and hospitality companies that operate chain stores should pay particular attention to the selected assumptions because these industries have unique aspects that could dramatically affect the end result. This is especially true when valuing a group of chain stores.
For the purpose of this article, chain stores will be defined as locations sharing a brand, central management, and standardized business practices that are either under shared corporate ownership or franchise agreements. Chain stores will want to ensure not only that their valuation provider receives sufficient data (so proper assumptions are selected), but also that those assumptions are included in their valuation analysis.
Choosing the Right Methodology
The most common reason a company in the retail and hospitality sector would require fixed asset valuation services would be for financial or tax reporting purposes.
There are three basic methods to estimate an indication of fair (market) value in a fixed asset valuation:
- The cost approach,
- The sales comparison approach, and
- The income approach.
The methodology to be selected is dictated by factors such as premise of value, purpose, data availability and accessibility, project timing, etc. However, the cost approach is probably the most likely to be selected, especially when several locations are involved in the analysis.
The cost approach incorporates the economic principle of substitution that states: an informed investor would pay no more for an asset than the cost of purchasing or producing a substitute asset with the same utility as the one being valued. The cost approach is based on the current cost to recreate or duplicate the asset less an appropriate allowance for all causes of depreciation: physical deterioration, functional obsolescence, and economic obsolescence.
Under this approach, reproduction and/or replacement cost new (collectively referred to as RCN) are typically estimated using the indirect or direct methods. The indirect method applies equipment-specific indices to the historical cost of an asset to estimate current reproduction cost. The direct method involves using published sources, cost estimating techniques, recent capital investments, and input from dealers and manufacturers to estimate current replacement cost new.
Why the Cost Approach Works for Retail & Hospitality
The cost approach provides a great framework that valuation experts can follow, as it incorporates a number of items important in an analysis from completeness to economics, and functionality of the assets and value premise. However, in order to successfully complete an analysis, a valuation provider must address some potential challenges inherent in the cost approach. Otherwise, there is a significant risk that the concluded values will be materially impacted.
In general, the starting point in an analysis would be to rely on the company’s fixed asset register because it contains a wealth of information. It provides an X-ray of the challenges and allows the specialist to select, in part, the appropriate assumptions for the analysis. Moreover, companies require a list of all assets valued so they can be incorporated into their books as a base point.
Given the above, there are limitations and issues faced when performing fixed assets analyses. The following are some of these challenges:
- Lump sums – The fixed asset register (FAR) may include a pool of different assets placed in service around the same time.
- Excess capital costs – Extra assets could be included in the FAR that might not be required for current operations.
- Duplicate assets – In certain situations, assets reflected in the register could include assets that had been replaced but remained in the register.
- Description – There could be a lack of description, which might impact grouping of assets and ultimately an understanding of what is in place versus what assets are missing.
- Accounting adjustments – The register might have been subject to accounting adjustments, including prior purchase price allocations, impairments, etc., which would affect the integrity of the data.
- Missing historical data – Historical data (i.e., acquisition date and cost) from when the asset was first placed in service might be missing.
The Facts That Affect Valuation Assumptions for Retail & Hospitality
The valuation method selected is only one piece of the fixed asset valuation process. A fixed asset valuation provider must also consider the circumstances that may affect the valuation and the assumptions the analysis will use.
During the diligence procedures for the fixed asset valuation, there are a number of facts that need to be considered and incorporated, as they could (and may) have a material impact in an analysis. The following represent some of those considerations:
- Classification – Valuation providers should ensure that assets with similar characteristics (e.g., type, life, usage) are properly categorized, as this will have an impact in how RCNs are estimated and/or apportioned.
- Store size – Certain assets are directly linked to the size of the store to help it operate as intended. This is key when estimating RCNs.
- Store type – In certain cases, a store type could have a different replacement cost estimate because certain locations may provide different services.
- Location – For certain assets, geographic location could have a major impact in the replacement cost, especially for assets that are labor intensive such as leasehold improvements. Labor cost tends to be higher in expensive metropolitan areas (e.g., New York City) when compared to the national average.
- New assets – It is important to consider capital investments incurred in recent years in the fixed asset valuation. New assets affect the analysis from an RCN perspective and could identify possible excess capital costs.
- Opening date – Understanding when the store first opened helps with asserting when the assets were first placed in service and possibly replaced, especially for longstanding stores.
- Remodel date and scope – Knowing the details of the remodel projects assists valuation providers in identifying when investments occurred and which assets were replaced.
- Future remodels – Identifying stores soon to be remodeled and understanding the extent of the remodel helps valuation providers in assessing the value of the assets that will be replaced as a result of the remodel.
- Relocations – If a store was relocated, the relocation could have an impact for certain assets (i.e., leasehold improvements) because these assets do not transfer with the store. Understanding when relocations occurred helps identify assets that might not be in place any more.
- Closures – If a store is expected to close, the assets in that store will experience a significant impact from that decision. In general, assets in stores that are soon to be closed would have a limited life (depending on the assets’ marketability).
- Real estate ownership – Valuation providers need to understand which locations are owned, leased, or ground leased. Each status will dictate how certain assets will be valued.
- Sale-leaseback arrangements – Sale and leaseback arrangements could have a major impact on fixed asset valuations. Certain assets placed in service on or prior to the sale-leaseback would transfer to another party and should not be part of the analysis.
- Lease terms – It is important to understand the terms of the lease, including renewal options as this has a direct impact in one of the major assets (i.e., leasehold improvements).
Knowledge is Key
The reality is that more often than not, providers need to make assumptions in order to draw conclusions in an analysis. The accuracy of some of these assumptions is critical to reaching a sound valuation conclusion. Clients can help ensure that the most appropriate assumptions are selected under the circumstances by understanding—-to the extent possible—and thoroughly discussing the factors described in this article with their valuation partner.
For More Information
Please contact Juan C. Crespo at email@example.com or 561.922.5111.