In an article published a few years ago in the Tanker Operator, a well-respected trade publication about the tanker market, we had discussed the three primary methods of vessel valuations: a) the market comparable approach, also known as ‘last done’ in shipping, b) the replacement cost method, and c) the income approach.
Each of these three methods has its advantages but also shortcomings, and each method may be better suited under certain circumstances. The market comparable approach reflects what the market will pay for an asset in nakedly materialistic, ‘cold money’; this approach is the default method for vessel valuations in standard loan agreements, but it’s also an approach susceptible to the ‘animal spirits’ of the markets, opaqueness, illiquidity, market dislocations, and all. The replacement cost method has been burdened by its backward-looking mentality and dependence on ‘historical cost’, and thus this approach has been limited to valuing unique, customized and non-mainstream assets. The income approach ought to be the preferred way of valuing vessels (and all sort of investments) since it depends on expected earnings during the asset’s remaining economic life. However, as ‘fundamental’ or ‘intrinsic’ this way of valuing assets may be, the devil is in the details, as they say; since expectations for future earnings can vary widely based on many factors, including the ability to generate them – a more competent investor (buyer) can generate more profits than a poor performer, and also the cost of capital – better capitalized investors (buyers) have a more effective capital structure with lower costs, the income approach valuation methodology can lead to a wide-ranging values. In the hands of a scrupulous valuator, the income approach may be just a weapon of ‘mass destruction’ to work ‘backwards’ and generate any price for the price of the asset; just presume future earnings trends and justify a low discount rate, and voilá, the price can appear out of thin air.
There have been ‘variations on the theme’ for the income approach, such as Discounted Cash Flows (DCF), Net Present Value (NPV), etc. An income approach variation unique to shipping has been the method suggested by the Hamburg Shipbrokers Association (HVSS) three years ago and has been known as the Long Term Asset Valuation method (LTAV), also known as Hamburg Ship Valuation Standard (HSVS), also colloquially known as the ‘Hamburg Rules’ of vessel valuations.
It has widely been debated whether the ‘Hamburg Rules’ is a proper valuation methodology since the formula inputs for future earnings are ‘backward looking’ dependent on the ‘past performance’ of the last ten years (including the years of the unique super-cycle of freight earnings) will be achievable going forward (as proxy of future earnings, the average of freights for the last ten years is inputted.) Likewise, the discount rate suggested by the Hamburg Rules has been debated that could only be achieved by exceptionally well-capitalized companies at times that the finance cost is historically too low.
But again, when the market is so illiquid and the market comparable approach can only have indicative consequence, a valuator needs all the help they can get in order to value a vessel. For instance, in the last three years, only four VLCCs up-to-four years old have been sold. Not sure that the market comparable approach offers any better guidance on pricing than the ‘Hamburg Rules’ approach. Probably ‘gut feeling’ is a much better approach, although no self-respected valuator or accountant will accept such approach; but again, shipping is a poorly model-able industry.
© Basil M Karatzas 2013
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