Replacement Value (Valuation) - Explained
What is the Replacement Value Method?
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Table of ContentsWhat is Replacement Value (or Substantial Value) of Assets Method?Issues with Replacement ValueIntangibles and the Asset-Based Valuations
What is Replacement Value (or Substantial Value) of Assets Method?
A second, asset-based valuation method looks at the operating assets of a business and assigns a value based on what it would cost to replace them. This approach evaluates the cost of replacing the assets to achieve a commensurate output given the current state of technology in the industry.
This is important as industry innovations may offer better or cheaper methods of achieving the purpose of the company's assets. This is particularly common in technology-based businesses, as the available technology changes rapidly. This may cause the book value of the assets to differ considerably from the actual or market value of those assets.
Like the book value method, the replacement value method considers the value of each asset independently of the operations or productive capacity of the whole business. The values of the individual assets of the firm are added together to arrive at a valuation.
The replacement value is often subdivided into gross substantial value and net substantial value of the assets. Gross substantial value refers to an assets replacement value at market price. Net substantial value is the gross substantial value reduced by the liabilities owed that have recourse against the asset.
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Issues with Replacement Value
The replacement value method is not very useful in valuing a startup that has value as a going concern. This is particularly true when the venture has already achieved high growth rate. Replacing the physical assets of a startup is often quite easy.
The intangible factors, such as human capital, first-mover advantage and early brand recognition, intellectual property, etc., are the drivers of value in the startup venture. In summary, this approach does a poor job of valuing the intangible assets of the firm, as many of these assets are not capable of replacement. The importance of intangible assets is discussed further below.
The replacement value is, however, useful for certain internal valuations. Entrepreneurs or managers may be concerned with the replacement cost of key operational assets. Understanding the replacement cost serves as a risk assessment. This method can also be useful to individuals determining the cost of entering a given market.
While there are numerous intangibles that are incapable of replacement, an aspiring entrepreneur or new firm can use this calculation to determine the upfront and long-term asset costs associated with entering the market.
Intangibles and the Asset-Based Valuations
In addition to the failure of asset-based approaches to consider the entity value as a going concern, a salient deficiency of the asset-based approaches is the inability to accurately determine the value of intangible assets. This is particularly important is many startup ventures. These assets are difficult to value and often only have value within the business as a going concern.
Examples of valuable intangibles include: on-going business relationships, industry reputation, brand recognition, human capital (knowledge or experience), and intellectual property (trade secrets, trademarks, patents, copyrights, etc.). All of these are intangible assets that serve to increase the value of the firm. In other instances a firm may have intangible assets that put the company at risk. For example, the firm may be the subject of intellectual property litigation.