Economic obsolescence (EO) is the loss of value resulting from external economic factors to an asset or group of assets. EO is often encountered in valuation work performed for financial reporting purposes, bankruptcy emergence and in other practice areas when dealing with companies in capital-intensive industries. Identifying, measuring and applying the adjustment for EO can be a complex and iterative process, requiring expertise and interaction across multiple valuation disciplines, including real property, personal property, business valuation and intangible asset valuation.
There are many factors that may cause EO, including but not limited to:
- the economics of an industry;
- loss of resources (material and/or labor);
- new legislation and ordinances;
- increased cost of inputs (or the inability to pass on those costs);
- reduced demand, increased competition; and
- reduced earnings or margins and other factors and operating restrictions.
EO is frequently outside the scope of the owner’s influence or control, and it may occur anytime in an asset’s life.
EO manifests itself in the profit margin of business. If the operating margin of an asset or group of assets is below what provides a sufficient economic return to the supporting assets, and there is a difference between the existing operating level/capacity and a sufficient operating/level capacity, EO may be an issue.
Estimating the Level of Economic Obsolescence
The process of identifying and measuring EO requires input from specialists in fixed asset valuation and business valuation. VRC most often deals with EO related to fixed assets in the context of business combinations, where the assets are to be valued for financial reporting purposes pursuant to ASC 805. Ideally, the sum of the fair value of assets that comprise the subject company (e.g., net working capital + fixed assets + intangible assets (excluding goodwill)) is less than the purchase price, where goodwill will be residual. In some cases, the initial estimate of goodwill may be negative, although the cause of this may actually be EO rather than a bargain purchase. This is especially true in fixed asset-heavy industries, where the underlying economics of the assets drive the economics of the business.
Fixed Asset Valuation Considerations
In the initial stages of the valuation process, fixed assets are valued under an in-use premise by applying all necessary forms of depreciation (e.g., physical deterioration and functional obsolescence). The actual utility of the asset or asset group is then compared to its rated utility or capacity, which is the physical productive capacity of the facility at full operation as it exists at the time of valuation. Full utilization, depending on the type of facility or process, is generally in the range of 85 to 95 percent of capacity, as most facilities have some normal amount of downtime for routine maintenance, equipment changeovers, etc. If an asset is less than fully-utilized, the EO adjustment would be applied directly to the asset in the determination of fair value.
If the initial view of the transaction suggests potential EO, or other business, industry, or economic factors suggest a high likelihood of EO, it is also prudent to estimate the floor value of the fixed assets subject to the potential EO indication, which is typically based on the net orderly liquidation value (NOLV), or salvage value of the assets. Determining the floor value provides assurance that the EO is not overestimated. Generally, post-EO fair values will fall somewhere between the value-in-use and NOLV. However, in cases where the EO is likely to be significant, forced liquidation value (FLV) can be used to support the floor values.
If the subject entity or asset group owns real property, the appraiser must determine whether or not EO is applicable and to what components. The application of EO to real property may differ in nature from that of personal property given that the approach to value for land is a based on comparable sales (which assumes a sale or orderly liquidation).
Business Valuation Considerations
Once the fixed assets are valued under an in-use premise (as if no EO was present) the fair value of all identified net assets (including any other assets in scope) must be reconciled to business enterprise value. Within the context of a purchase price allocation under ASC 805 or asset impairment analyses under ASC 360, asset values are initially measured discretely, and EO is potentially indicated when a purchase price or allocated enterprise value does not support the sum of discretely-measured tangible and intangible asset values. If the fair value of the fixed assets plus working capital and intangible assets (excluding goodwill) fit within the purchase price or enterprise value, further refinement may not be required as one may conclude that the value of the fixed assets is reasonable. However, if the purchase price or enterprise value remains lower than the sum of the fair value of the assets or thus the initial implied value of goodwill is negative, it may suggest that further review of the fixed assets (within the continuum of OLV to in-use fair value) and the related returns are necessary to determine the level of EO.
In the case of a single-plant, single reporting unit company, the purchase price or enterprise value of the total company will determine EO. The following example illustrates this simple single-unit example in which initial valuation procedures indicate that the total fair value of the acquired assets exceeds the purchase price. In this case, it is assumed for simplicity that identifiable intangibles are de minimis.
The calculations, without further examination, would suggest a negative goodwill indication. However, if it is determined that this gap exists due to a loss of value in the fixed assets arising from external factors, as opposed to transaction-specific facts and circumstances (e.g., distressed sale), it is necessary to perform additional steps related to EO in the fixed assets.
Once the total EO is estimated, it is often spread across the appropriate fixed assets (typically personal property and buildings) taking into account the floor values of the individual assets. This may not be an even, or pro-rata allocation across all fixed assets. As noted, EO may not be applicable to land given the market-based approach utilized to determine the fair value of land.
In certain instances involving more complex or diversified operations, it may be necessary to disaggregate total company value, reporting unit value or purchase price among groups of assets (e.g., on an individual location or plant basis). The number of units to be considered depends upon the structure of the business, and the interrelated or disaggregated nature of plants, asset groups and reporting units. When a company has multiple plants or asset groups, it is often necessary to determine whether EO is a function of the business as a whole (and therefore applicable ratably to all fixed assets), is applicable only to specific assets or groups of assets or whether certain assets have a higher degree of EO than other assets. This the relative allocation of enterprise value to the different components of the business can be derived via a series of discounted cash flow (DCF) models which reconcile back to the aggregate value, in consideration of the asset-specific characteristics and floor value estimates prepared by fixed asset professionals. It can be determined that certain plants have no EO as their economics fully support the in-use fair values of the individual assets, while others may have low profitability and considerable EO.
Intangible Asset Considerations
The identification of intangible assets should be considered when EO is present in the fixed assets. Whether or not assets such as patents/technologies, brands and customer relationships have positive fair value in a situation where fixed assets are penalized for not generating sufficient returns is a rather subjective assessment that requires careful consideration of business/industry, relevant reporting units and operations and market participant factors. In practice, intangibles are frequently assigned no value or minimal value in components of the business where significant EO is present in the fixed assets. This reflects the grouping of assets and the lowest level for which there are identifiable cash flows, as well as attribution of cash flows to fixed assets and intangible assets and the floor value of fixed assets (as described above). In other cases, customer-related intangibles or IP-related assets that could have value to other market participants may be ascribed a positive fair value. However, this can be an area of diversity in practice, which should be addressed early, as it will affect the magnitude of the EO adjustment. A market participant perspective, both qualitatively and quantitatively, is critical to determining the fair value of the assets with appropriate attribution of EO.
Often it can be apparent from the onset of an engagement that there is some level of EO present. The expertise and interaction across multiple valuation disciplines, including real property, personal property, business valuation and intangible asset valuation, is essential in identifying and determining the EO in fixed assets and can have a material impact on the conclusions of value. It is important to recognize this issue as early as possible and have the appropriate teams in place to execute the analysis expertly and thoroughly.
For a more in-depth conversation about how VRC can develop a valuation assessment for your business, please feel free to contact the article authors or your VRC professional.