Asset Management

Income approach to valuation of Water and Sewer assets

  • 1.  Income approach to valuation of Water and Sewer assets

    Posted 23 days ago
    Hello everyone,

    If I am not mistaken, for valuation of councils' Water and Sewerage Network assets for the financial reporting purposes the so called "cost approach" is used. Based on the requirement of accounting standards (AASB 13) this approach reflects the cost to build the asset with the same current service potential. Other approaches to valuation (market and income) are considered as not reliable due
    to the specialised nature of the assets valued.

    However, correct me if I am wrong, in NSW water and sewerage businesses within councils are operated under competitive neutrality principles which means they would reflect market based water and sewerage charges. In other words, the businesses supposed to generate profit (which may not always be the case though but still). If this is the case, then the income approach to valuation of water and sewerage assets would be more reliable as it will be based on observable inputs compared to the cost approach which is purely unobservable inputs valuation and subject to high level of judgement.

    Though it should be noted that income approach would also consider unobservable inputs: discount rates, future cash flow projections, etc. But still, as an auditor in the past I would consider the income approach to valuation more reliable and auditable.

    My only concern at this stage is that this approach would give us the fair value of the business as a whole. Then it should be allocated b/w the assets which may be not an easy exercise.

    What would be your thoughts on that?

    And, if you know any councils or water corporations which utilise income approach to valuation of its water and sewerage supply network assets, please let me know.

    Thanks,
    Igor.


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    Igor Ivannikov MPhil (UNE), FCCA, CA
    Local Government Financial Consultant
    iivannikov100@gmail.com
    P: 0412 932 174
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  • 2.  RE: Income approach to valuation of Water and Sewer assets

    Posted 22 days ago
    Hi Igor,

    Your thoughts on this matter are progressive and in line with commercial realities. The Cost Approach to valuation is in fact still a market based valuation methodology, even if it doesn't rely on direct comparison to market evidence (observable inputs). It simply requires, in the absence of observable data, the application of what market participants would take into consideration when purchasing assets for which there is very little, if any, evidence of comparable transactions.

    The asset management professional also requires a tool that they can utilise to cost existing assets, forecast values, renewals and maintenance liabilities and then make decisions on prioritised works and future budget requirements. Unfortunately, the workings of the Cost Approach to valuation seem fit that need and thus, the approach has been sanitised and widely adopted by entities to meet these asset management needs without the entity fully understanding the approaches true purpose.

    Focusing on water and sewer networks, if there was income derived from the use of the networks to supply services, then there is the beginnings of a basis for an alternate approach to valuation. Even if the network is not deriving an income, if only the potential exists, then there is a basis for an alternate approach to valuation. As Government becomes more commercially focused and less able to fund infrastructure; we are seeing a plethora of public/private partnerships across all sectors (health, justice, education, roads, etc). In these arrangements, the private partners are not benevolent but demanding of a secure income stream at an acceptable rate of return for themselves or their investors. The Macquarie Infrastructure Group being a prime example of wealth creation through infrastructure investment.

    The query regarding whether the income approach to valuation truly reflects asset value or whether it also reflects a business practice and/or goodwill is a good one. There exist a number of business types for which goodwill and management comprise nearly all of their value (i.e. consultancy services, marketing firms and so on) and then there are the austere businesses, such as network providers, that rely on their asset base to derive income and, where possible, they try to overlay this with goodwill. It is easier to comprehend if you compare say, McDonalds food chain where alternatives are abundant and strong branding is imperative to success against the likes of Transurban, the largest toll road company in Australia, whose requirement to differentiate (at least to the public) is less of a requirement.

    In valuation there exist a number of property types that are sold in conjunction with their businesses and which are generally accepted as being valued using the income approach to valuation. These include caravan parks, hotels, motels, child care centres, medical centres, marinas and so on. All these properties are valued based on good average business management (defined as reflecting industry standards with regard to income generation, etc). Valuers that specialise in these property types know, if a business is performing better than what the asset base would normally accommodate (again, by comparison to industry revenue averages) and then seek to discover whether that 'superprofit' is derived from the goodwill of the business or some other competitive advantage (which may or may not be sustainable). Effectively, the valuer will discount any intangible such as goodwill if it cannot be sustained after the transfer of ownership. It should also be noted these properties can split their values into leasehold and freehold interests.

    Long story short, in our opinion network assets have limited intangible 'goodwill' and could be valued on an income approach to valuation with little need for adjustment to accommodate the value of the 'business', (and assuming income generation could be established, actual or opportunity cost). Remembering of course the basement value of the network is its disposable (break-up) value.

    The question raised by you is really, how best to assess what the asset (in this case networks) would transact for in the market place? A commercial enterprise would try to derive value by using a discounted cash flow analysis approach which assesses a future net income stream over a defined financial horizon, taking into consideration acquisition costs (legal, environmental, etc), necessary capital expenditure and using an internal rate of return benchmarked against their investors' appetite for risk.

    We hold, to say that infrastructure cannot be valued using something other than a depreciated replacement cost (where depreciation has no reference to market forces) would be incorrect, but implementing alternate methods may take some effort and client support.

    Like most things, change requires demand and at present, there is little appetite within Government to start analysing potential income streams from public sector assets
    .

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    Martin Burns
    National Director of Valuations
    Liquid Pacific
    North Sydney NSW
    02 9025 3788
    solutions@liquidpacific.com
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  • 3.  RE: Income approach to valuation of Water and Sewer assets

    Posted 17 days ago
    Hi Martin,

    Thanks a lot for your input. That's really interesting especially given your valuation expertise.

    I noticed you mentioned child cares as one of the example of businesses which can be valued using income approach. I know for sure that many councils have child cares under their controls. But when it comes to the valuation of council's assets, the child cares assets are valued separately using cost approach (building, equipment). Land is also valued separately but in most cases using market approach. Assuming that the building's and land's highest and best use (AASB 13) is "child care" then councils might probably ask for valuation of this using income approach (based on "good average business management"). Some child cares are also sold by the councils as non core business for the council and inability to manage it effectively.

    A lot of thoughts for empirical research I think :)

    Cheers,
    Igor.  


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    Igor Ivannikov CA, ACCA
    Local Government Financial Consultant
    iivannikov100@gmail.com
    P: 0412 932 174
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  • 4.  RE: Income approach to valuation of Water and Sewer assets

    Posted 17 days ago
    Hi Igor,

    Probably a better example of where the income approach is under-utilised  within Councils is the valuation of caravan parks. We know of Councils sitting on millions, if not tens of millions of dollars worth of caravan park assets but elect to value these using a Cost Approach, whilst ironically receiving literally millions in gross income per annum.

    One for the audit community maybe?


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    Martin Burns
    National Director - Valuation
    Liquid Pacific
    North Sydney NSW 2060
    www.liquidpacific.com
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  • 5.  RE: Income approach to valuation of Water and Sewer assets

    Posted 20 days ago

    Hi Igor

    I agree with Martins comprehensive response, especially the observation that infrastructure businesses "can indeed be valued using an approach other than depreciated replacement cost……. but implementing alternate methods may take some effort and client support".

    In terms of WHO does this in the water industry, I think you'll find that Yarra Valley Water use a business-based estimate of their assets (and I'm pretty sure that Hunter Water used to do so as well but I think they switched back – or reconciled the asset value to fair value as discussed below). What tends to happen is that water business that apply a commercial measure of "fair value" tend to have a lower "value per connection" than those who use a replacement value. One explanation of this is that it may reflect the tendency of water businesses to keep their pricing lower than they might be if they were fully commercialised. To put it another way, the price isn't seen as the best measure of a business in an industry whose outcomes are fundamental to a raft of social, economic and environmental policy outcomes.

    If you compare water businesses to a listed infrastructure business like Transurban you'll find marked differences in the capital structure (level of debt) and associated pricing. This is not a criticism of Transurban but an observation that they are far more commercially attuned than the water business may be.

    It's a vast oversimplification but, if your business earnings are tied to its asset value (i.e. revenue = operating cost + rate of return x regulated asset base (RAB); therefore earnings = revenue – operating cost = rate of return x RAB) and assuming you earn the rate of return then the valuation question can become a circular argument as fair value = RAB.  

    So, regarding the applicability of "fair value" as a DCF of earnings vs depreciated asset costs. We know that the water business is capital intensive (i.e. capital decisions can define 80% or more of the businesses cost structure). So, if you are a water business that has a lot of new assets (and hence the Op X and Cap X (particularly renewal) is likely to be low for a long period) then a shift to "fair value" is likely to be justified. If youre not in that situation then, as Martin said…" implementing alternate methods may take some effort and client support"



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    Chris Adam
    cadam@strategicam.com.au
    0428461893
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  • 6.  RE: Income approach to valuation of Water and Sewer assets

    Posted 17 days ago
    Hi Chris,

    Thank you for your reply. Very interesting.
    I will also look at the examples you referred to.

    Cheers,
    Igor.

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    Igor Ivannikov CA, FCCA
    Local Government Financial Consultant
    iivannikov100@gmail.com
    P: 0412 932 174
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