The Three Valuation Approaches: Market, Income and Cost
Every method belongs to one of three approaches. Know which, and when each one fits.
Every valuation method belongs to one of three approaches. The market approach looks at prices of the same or similar assets. The income approach converts future income or cash flows into a present value. The cost approach asks what it would cost today to replace the asset's service capacity, less the value it has lost.
The approaches are the same for a flat in Pune and for shares in an unlisted company; the methods and inputs differ. This page sets the three side by side. The real-estate and business-valuation pages go into each method.
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The Three Approaches at a Glance
Core idea
Market approach
Prices from transactions in identical or comparable assets
Income approach
Future amounts converted to a single present value
Cost approach
Cost to recreate the same utility, less obsolescence
Used when (VS 103)
Market approach
Asset or comparables trade in an active market, or there are recent orderly transactions
Income approach
No or few comparables, or the asset produces income that can be projected
Cost approach
Asset can be quickly recreated, liquidation value is needed, or the other two cannot be used
Land and Building methods
Market approach
Sales comparison using sale instances, with adjustments
Income approach
Rent capitalisation, discounted cash flow for projects
Cost approach
Land value plus depreciated replacement cost of the building
SFA methods
Market approach
Market price, comparable companies multiple (CCM), comparable transaction multiple (CTM)
Income approach
Discounted cash flow, earnings capitalisation; relief from royalty and MEEM for intangibles
Cost approach
Net asset value, adjusted book value, replacement cost of intangibles
| Market approach | Income approach | Cost approach | |
|---|---|---|---|
| Core idea | Prices from transactions in identical or comparable assets | Future amounts converted to a single present value | Cost to recreate the same utility, less obsolescence |
| Used when (VS 103) | Asset or comparables trade in an active market, or there are recent orderly transactions | No or few comparables, or the asset produces income that can be projected | Asset can be quickly recreated, liquidation value is needed, or the other two cannot be used |
| Land and Building methods | Sales comparison using sale instances, with adjustments | Rent capitalisation, discounted cash flow for projects | Land value plus depreciated replacement cost of the building |
| SFA methods | Market price, comparable companies multiple (CCM), comparable transaction multiple (CTM) | Discounted cash flow, earnings capitalisation; relief from royalty and MEEM for intangibles | Net asset value, adjusted book value, replacement cost of intangibles |
Cost Approach Terms the Exam Separates
- Replacement cost
- The cost a market participant would incur to create an asset with comparable utility, adjusted for obsolescence. The new asset need not be physically identical. VS 103 also calls this the depreciated replacement cost method.
- Reproduction cost
- The cost of creating a replica of the asset, adjusted for obsolescence.
- Physical obsolescence
- Loss of value as the asset's useful life is used up.
- Functional (technological) obsolescence
- Loss of value because newer, more efficient alternatives exist.
- Economic (external) obsolescence
- Loss of value from outside factors: changed regulation, excess supply, high interest rates.
Worked Example: Reconciling Three Results
Illustration only. A 4,000 sq ft office floor in Andheri East, Mumbai, let at market rent.
Market
Working
Three recent sales in the same building at ₹25,000 to ₹27,000 per sq ft; adjusted rate ₹26,000 × 4,000 sq ft
Indication
₹10.40 crore
Income
Working
Net annual rent ₹72 lakh ÷ capitalisation rate 7%
Indication
₹10.29 crore
Cost
Working
Undivided land share ₹5.0 crore + depreciated replacement cost of construction ₹4.6 crore
Indication
₹9.60 crore
| Approach | Working | Indication |
|---|---|---|
| Market | Three recent sales in the same building at ₹25,000 to ₹27,000 per sq ft; adjusted rate ₹26,000 × 4,000 sq ft | ₹10.40 crore |
| Income | Net annual rent ₹72 lakh ÷ capitalisation rate 7% | ₹10.29 crore |
| Cost | Undivided land share ₹5.0 crore + depreciated replacement cost of construction ₹4.6 crore | ₹9.60 crore |
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Reading the Example
Market and income agree within about 1%, and both rest on observable data from the same micro-market. The cost result is lower because a Grade A office floor in a mature business district commands a location premium that cost does not capture. A valuer here would conclude near ₹10.3 to ₹10.4 crore, relying on the market and income approaches and explaining why cost was given little weight.
VS 103 is clear on the method: where approaches give significantly different values, the answer is not reached merely by averaging or weighting them. The valuer has to explain the difference. It also says approaches should maximise relevant observable inputs and minimise unobservable ones.
How the Valuation Examination Tests This
- check_circleClassification: 'which approach does net asset value belong to?' (cost) or 'relief from royalty?' (income). Learn the method list under each approach.
- check_circleReplacement versus reproduction: comparable utility versus an exact replica. Both deduct obsolescence.
- check_circleObsolescence types: a new metro line that cuts footfall to a mall is economic, not functional.
- check_circleReconciliation: an option that simply averages three very different results is usually the wrong answer.
- check_circleIn the Land and Building paper, the three approaches together carry 21 of the 35 marks in Valuation of Real Estate, so they are the core of the exam.
FAQs
What are the three approaches to valuation?expand_more
The market approach (prices of comparable assets), the income approach (present value of future income or cash flows) and the cost approach (current cost to replace the asset's utility, less obsolescence).
What is the difference between replacement cost and reproduction cost?expand_more
Replacement cost recreates the same usefulness, possibly with modern materials and design. Reproduction cost recreates an exact replica. Both are then reduced for physical, functional and economic obsolescence.
Which valuation approach is best?expand_more
None in general. VS 103 makes the choice depend on the nature of the asset, the reliability of available inputs, the strengths and weaknesses of each approach, and what market participants use.
Can a valuer use more than one approach?expand_more
Yes, and it is common practice. If the results differ significantly, the valuer must investigate and explain the difference rather than average them mechanically.
Next steps
- Market Approacharrow_forward
- Cost Approacharrow_forward
- DCF valuationarrow_forward
- Bases of Valuearrow_forward
Timed and scored, with negative marking.