Bank valuations usually reflect a more conservative appraisal of an asset’s value. These appraisals determine how much money is “safe” to lend a borrower, which means anyone planning to buy or access the equity in their asset(s) cannot simply depend on its market value.
Valuers typically employ various approaches to appraise assets in a way that minimises risks for the bank. Bank valuations that fall below the borrower’s expectations may seem like an opinion-heavy appraisal, but there is really a numbers-heavy logic behind these conservative assessments.
Professionals look at factors such as size, location and structural condition for property valuation and corporate equity (operating and non-operating assets) and transactions for businesses. However, there’s no one-size-fits-all formula so valuers must consider various methods to come up with a fair value.
Some of the more common valuation methods used to appraise assets are listed below.
Valuation methods part 1: Properties
Asset appraisal is a numbers game. While market value typically responds to the market’s emotion or demand, bank valuation secures the most logical price of an asset based on factors that affect its value and how much it could realistically fetch when sold at a loss.
Professional valuers turn to one or a combination of the methods below to determine the best value for an asset—at least from the bank’s perspective:
Sales comparison
Just as its name suggests, the sales comparison method requires the valuer to research similar assets that have been sold in the same area for a specific period—typically the past half year—to identify a price range for a property.
The comparison enables valuers to determine a more realistic value for a property since it identifies the price range that potential buyers are willing to pay.
Cost or Summation
The cost or summation method involves summing up the value of the land, structure and any structural improvements added to the property, though this mostly works on newer properties.
The theory is that it is possible to estimate the property’s value by adding the value of improvements and deducting the cost of depreciation or damage.
Income capitalisation
The income approach is mostly used for income-producing assets such as investment and commercial properties.
This method requires the valuer to use market data to determine a property’s value by applying capitalisation rates to the property’s net operating income (NOI), or the gross potential income (GPI) minus all costs, losses and expenses related to managing the investment property.
The valuer would typically assume that the property is leased at arm’s length or market value at its normal occupancy levels.
Valuation methods part 2: Businesses
Investment banks value companies depending on its level. This ensures that start-ups don’t get compared to mature companies and make it seem like it is lagging behind its competitors.
Three common methods in company valuation are:
Precedent transactions
The precedent transaction method is similar to the sales comparison method for properties. Valuers derive the value of a company by comparing it to other similar businesses that have been acquired or sold at a certain time frame.
Although the precedent transaction approach is useful for companies entering into a merger or acquisition, values derived using this method can easily become stale because market conditions can be quick to change.
Discounted Cash Flow (DCF) analysis
The discounted cash flow analysis requires a valuer to consider a company’s historical, current and potential future financial performance in order to analyse its value.
This method is very quantitative in nature since it usually relies on past and current income statements to forecast a company’s financial potential, although it is still important to consider external factors—such as business competition or the market cycles—in order to come up with a fair valuation.
Liquidation Value and replacement cost
This type of method is typically used to determine the value of distressed companies or businesses that incur more loss in capital and have decided to liquidate by selling loss-making assets.
Using this method, companies can recover some value from the sale of liquidated assets. When these assets are replaced and lead to the creation of better opportunities for the business, the company receives an increase in value as well.
What is the best valuation method?
There is no single valuation method that stands out from the rest and each asset must be assessed according to its specific circumstances.
Professional valuers use different methods to appraise a property or business for banks, but the bottom line to any bank valuation is that the end value must protect the lender’s financial security.
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