It is critical to any business valuation engagement to define the standard of value at the beginning of the project. The standard of value ultimately dictates the true value of a business for a given purpose. It is true that value is what a buyer and seller agrees to, however for various purposes from tax reporting to mergers and acquisitions the value changes significantly as the process to arrive at value differs.
For many situations, the standard of value is legally mandated, whether by law or by binding legal documents or contracts. In other cases, it is a function of the wishes of the parties involved. The standard of value usually reflects an assumption as to who will be the buyer and who will be the seller in the hypothetical or actual sales transaction regarding the subject assets, properties, or business interests. It defines or specifies the parties to the actual or hypothetical transaction. In other words, the standard of value addresses the questions: “value to whom?” and “under what circumstances?” The standard of value, either directly by statue or (more often) as interpreted in case law, often addresses what valuation methods are appropriate and what factors should or should not be considered.
There are five standards of value:
1. Fair Market Value
2. Investment Value
3. Intrinsic Value
4. Fair Value (State law)
5. Fair Value (Financial reporting)
The focus of our discussion today is Fair Market Value vs. Investment Value, how they differ and its application.
Fair Market Value
The term fair market value is defined as follows:
The price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts.
The term investment value is defined as follows:
The specific value of property to a particular investor (or class of investors) for individual investment reasons. Investment value considers a specific investor with specific motives and investment criteria rather than the hypothetical investor of fair market value who evaluates all data to make a rational decision.
Fair market value is the standard of value utilized for tax reporting such as valuations for estate and gift tax purposes. Investment value is the true economic value to a specific investor, which could incorporate synergies to be potentially achieved by investment in a company. Investment value is largely utilized for management planning purposes for valuations in mergers and acquisitions.
In subsequent articles we will cover the remaining three standards of value and the three commonly used valuation approaches.