Author: Steven McDonald, CVA, Chief Economist/Valuation Services (Email)
Determining the value of a utility system is something we’re being asked to do more and more. When someone is thinking about this, we often hear, “Is it worth what it cost to build with some deduction for the passage of time and “wear and tear”? Or is it only worth what someone can borrow from the revenues left over?” Often the answer is, “It depends.” Most importantly, when considering the value with respect to a possible sale, litigation, or insurance coverage, the answer should always be found in a business valuation (or appraisal) and not in a financial or engineering analysis or evaluation.
A utility system is a special purpose property. Since the assets are specifically designed, configured, and constructed solely as a utility system, no alternate highest and best use should be considered in developing a price for a possible transaction. In addition, ownership of this special purpose property would be expected to include a bundle of rights that could include (if applicable to the system), but not limited to, physical assets, certain real property, water withdrawal permits or rights, water and sewage treatment permits, wastewater discharge permits, operational rights, service area rights, as well as other tangible and intangible assets.
As a special purpose property, we know it will continue to be in business, so there is no going concern value for land, buildings, and equipment. Utility systems operate without competition, and deliver an essential public purpose use to a protected, defined service area. As such, the development of a “value,” whether defined as Fair Market Value, Fair Value, or Investment Value, requires appropriate application of procedures, approaches, and methods that conform to the Uniform Standards of Professional Appraisal Practice (“USPAP”) Standard 9.
While the application of procedures, approaches, and methods required by USPAP rely heavily on financial and engineering concepts, they go beyond the common applications of a pro forma, net present value, or cost estimating. A credible Business Valuation requires the knowledge, training, and experience to develop a value (or price) for something that has not yet been traded in a competitive economic market. It is a process of simulating the most likely outcome under expected market conditions, whether they are highly competitive or monopolistic. And it all starts with defining what “value” means – which is generally the most commonly misapplied concepts when asking what a utility is worth.
Internal Revenue Service (“IRS”) Revenue Ruling (“Rev. Rul.”) 59-60, 1959-1, C.B. 237, along with Treasury Regulations § 25.2512–1 and § 20.231-1 defines Fair Market Value as:
“The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.”
IRS Rev. Rul. 59-60 further states…
“…in addition that the hypothetical buyer and seller are assumed to be able, as well as being willing, to trade and to be well informed about the property and concerning the market for such property.”
As a result, a Fair Market Value standard should reflect the most “pure” value or price that would be expected to occur in a competitive economic market, whether highly competitive or monopolistic. The purity of value or price simply suggests that it would be unencumbered by specific, individual circumstances that may or may not impact the economic concepts of “willing and able.” Defining “value” and considering its application to an assignment at hand is one of the most important aspects of a credible Business Valuation/Appraisal.
Where a financial or engineering analyses or evaluations go awry is that they focus entirely on specific, individual circumstances. An example is assuming that the value of a utility system is solely reflected in what it cost originally or what it might cost to replace in today’s prices, less some deduction for depreciation. While physical assets can account for a significant portion of what it might be worth, this approach alone potentially ignores the value created with intangible rights. It assumes that a potential buyer is only interested in the physical nature of the utility, when ownership rights to the service area or water consumption, for example, could be equally, more, or less valuable.
But even when financial analyses or evaluations are combined to suggest a market value, they can be applied in ways that mitigate the assumptions necessary for a Fair Market Value. For example, when both buyer and seller are known it is common to apply existing financial constraints. Sometimes these conditions are applied from the current owner’s perspective as-if also constraining a potential buyer. For example, it is common for financial analyses or evaluations to focus on debt capacity or how much someone could afford to pay. There might be situations where that is appropriate, but at minimum it results in a Fair Value or Investment Value, not Fair Market Value. The lack of ability of one individual, even though willing, to afford a transaction price should not be assumed to be true for the entire market.
The bottom line is that utility systems create value—sometimes more or less—than we might consider using traditional financial or engineering analysis or evaluation. The best option for credible value, however it is defined, would be to engage firms such as Raftelis with professionals accredited in Business Valuation/Appraisal.