Fair Market Value

When we say "value", we generally mean fair market value, defined as follows:

The fair market value is the price at which the 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.214

It is interesting to note that, at least among taxing, finance, and valuation authorities, there is very little theoretical debate about the standard of value. The market of buyers and sellers—not the labor inputs in a commodity, its social worth, or its cost of production to the seller—defines value.215

The Gold Standard of Value: Actual Market Transactions

We present below some innovative ways to estimate value in the context of tried-and-true advice from other practitioners in the field. In doing so, we will always define value as f air market value, the price a willing buyer would pay to a willing seller with both having adequate information. An actual market transaction of this type is the gold standard of valuation.

Estimation Methods vs. Actual Value

The chapter could stop here if there was a ready market for all assets and they all traded frequently in standardized commodities. However, closely held businesses, various securities of small- and medium-sized companies, most investments in real estate, and many other assets do not. Therefore, techniques of estimating the value of these assets have been developed.

In this chapter, we describe three approaches to estimating value and provide quantitative models for the income approach. When actual market transactions are not available, projecting and then discounting the future income from an asset is often the best method of estimating its value in the open market.

214 This particular statement occurs in the Code of Federal Regulations, Title 26, Chapter 1, Part 20, Section 2031-1. However, almost identical statements appear in almost all references to fair market value. See "Other Value Standards" on page 249 for other standards of value.

215 On this point, the economics literature is the more obtuse. Ideas such as mercantilism and the labor theory of value floated about for centuries, which grounded value in nearly meta-physical qualities that may never meet the market. By comparison, the basis of accounting is historical cost—a specific fact with little metaphysical about it.

However, do not confuse an estimate using a specific method with an actual transaction price. All valuation methods are attempts to estimate the price to which a willing buyer and seller would agree. This distinction between an estimate of a parameter and the underlying parameter is normally quite explicit in disciplines such as statistics, econometrics, and economics.216 Such a distinction is vital in financial valuation as well but is sometimes missing in valuation reports and the discussion of such reports. To be clear, when we use the term value as a verb in this book, we mean estimating the sale price upon which a willing buyer and seller would agree.

Other Value Standards

While we will discuss fair market value, defined by willing buyer-willing seller arm's length transactions, there are other variations of the term "value" which are occasionally used.217 In particular:

1. Inrinsic value: This is the value of the securities of a company based on the underlying (or intrinsic) value of the company's assets.218 Intrinsic value will often vary from the market price for a variety of reasons, including the fact that securities in a company are not the same as an actual fractional interest in all the company's assets.219 Businesses are owned through securities, but those securities are not the same as a fraction of all the firm's assets.

216 In statistics and econometrics, even the symbols for the variables have evolved to indicate whether a certain quantity is an (often unknown) parameter or an estimate for one. For example, the known sample mean of a random variable X is often expressed with a bar over the variable, and the Greek letter mu is often used to describe the unknown population mean. The relationship between the two is summarized as EX =p which means that the mathematical expectation of the sample mean is the population mean.

Similarly, a common practice in economics (especially since the advent of "rational expectations" models) is to incorporate expectations of consumers or workers in modeling their current behavior. The difference between those expectations (which are normally unknown) and the actual variables is quite explicit.

217 An excellent reference on this topic is by Shannon P.Pratt, Robert F.Reilly, and Robert P. Schweihs, Valuing a Business, 3rd ed. (New York: McGraw-Hill, 1996), Chapter 2.

218 For example, an investor may look at the underlying real estate investments owned by a REIT (a publicly traded Real Estate Investment Trust) and believe that the intrinsic value of those assets is higher or lower than the market capitalization of the firm. If the intrinsic value is higher, he or she may decide to buy stock in the hope that the rest of the market eventually feels the same way.

219 I cannot improve on George Lasry's observation that "a thirsty stockholder in a brewery cannot walk into 'his' company and demand that a case of beer be charged to his equity account." George Lasry, Valuing Common Stock (New York: AMACOM, 1979); quoted in Pratt et al, Valuing a Business, Chapter 3. Pratt et al. also list court cases dating to the U.S. Supreme Court's 1925 decision in Ray Consol. Copper v. United States (45 S. Ct. 526) in which the Court declared that "the capital stock of a corporation, its net assets, and its shares of stock are entirely different things "

There are further, specialized meanings for the term intrinsic value in the investment community. The search for intrinsic value in stocks is a well-established technique that is sometimes called value research20 In addition, a portion of the market value of certain options is its intrinsic value.221

2. Investment value: This is the value a particular investor would place on an asset. Note that the investment value depends on the investor and, therefore, will not be the same for all investors.222 The market value, however, will be the same.

3. Fair value: This term is inherently vague and, therefore, must be defined by a statement of "fairness." Indeed, the term is often used in laws and regulations in which the fairness criteria should be spelled out.

There are some typical uses. One involves business combinations such as mergers or acquisitions, or transactions among equity holders in a business. The fair value here may not be the value set in an open market, where there are many buyers and sellers. Instead, the fair value is the price to which these parties would agree to buy and sell an asset without any compulsion.223 Such prices may deviate from the fair market value because the asset owners or acquirers would be few in number, and their willingness to pay for a particular asset may not match the prices set for similar assets in the open market. However, fair value should be reasonably close to fair market value because arbitrage possibilities should keep the value to even an unmotivated buyer reasonably close to the market price. Furthermore, allowing fair value to be markedly different from market value would allow for abusive tax evasion.224

220 There are many other investment styles, including market-timing, asset-allocation, market indexing, technical or "chartist," and the tried-and-occasionally-true "dartboard" approach.

221 For a call option (the right to purchase an asset at a specified strike price K) on a stock with a spot (current) price of S, the intrinsic value is max(S-K, 0). The remaining portion of the option premium is its time value. See, e.g., N.Chriss, Black Scholes and Beyond (New York: McGraw-Hill, 1997); P.Brandimarte, Numerical Methods in Finance: A MATLAB-Based Introduction, (New York: John Wiley & Sons, 2002).

Options are discussed further in "The Real Options Method" on page 260.

22 This term is sometimes confused with intrinsic value. However, there is a difference; an investor may not wish to purchase stock in a company that he recognizes has substantial intrinsic value. The investment value to that investor of the asset is much lower than its intrinsic value.

223 See Financial Accounting Standards Board, Statement of Financial Standards No. 141, "Business Combinations," September 2000. The FASB Web site is: http://www.fasb.org.

224 For example, the break-up of a firm may require the various investors and lenders to place a fair value on the underlying assets. If the fair values are different from the market values, the taxes paid on gains or losses on these assets will be significantly different from what should be paid. In some cases, this difference is merely a deferral. In others, it would amount to an abusive tax shelter.

In addition, the disclosure of fair values of assets and liabilities, based on market values, helps prevent investors from being misled about the prospects or performance of a company.

Note that the Financial Accounting Standards Board, in line with the effort of regulatory bodies throughout the financial industry, is currently revising its statement of fair value to bring it closer in line with fair market value.225 4. Liquidation value: The value of a firm that is being liquidated is almost always lower than that of a going concern, and is clearly different from its fair market value as an ongoing business.226 When assets are being liquidated, the conditions of the sale will often affect the market price significantly. For this reason, various types of liquidation value (such as "forced" and "orderly") are used to distinguish such a premise of value from the fair market value.227

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  • Medhane
    What is the definition of "statement of fairness"?
    6 years ago

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