What is Value? Standards of Value
To answer we must know “to whom” and “for what purpose”
By John M. DelGrego, CPA, ABV, ASA, Managing Director, Advisory Services
Valuing a business or business interest requires certain assumptions that include the presumed buyers and sellers. When appraisers are asked, “What is the value of my business?” the answer will depend on particular circumstances, such as “value to whom?” and “for what purpose?” As a result, the value of a business for a litigated matter could be completely different from the value of that same business calculated for estate tax compliance purposes or a strategic sale to a third-party buyer.
There are many definitions and interpretations of value. Accordingly, the appropriate standard of value must be identified in every valuation assignment in order to arrive at the correct conclusion.
To better understand this concept, think about valuing your car. If you were to sell that car to a third-party buyer, the value would most likely be higher than if you traded that same car into a dealership. Same car, different value, based on different transactional assumptions.
The four standards of value generally accepted in the business valuation community are as follows:
- Fair market value.
- Fair value.
- Investment/strategic value.
- Intrinsic value.
Fair market value is used in estate, gift and other tax valuations and is defined by the Internal Revenue Service in Revenue Ruling 59-60 as “an assumed price, in cash, that a hypothetical buyer would pay to a hypothetical seller for a business or business interest if it were sold on an open market.” It also assumes that neither party is under compulsion to buy or sell, and that both parties have reasonable knowledge of the relevant facts.
Under the fair market value standard, consideration is given to the marketability of the shares, or lack thereof, and the control inherent in those shares. The assumed price is without consideration of any special motivations by the buyer or seller that are not characteristic of a typical buyer or seller.
While used in tax engagements, fair market value is also quite often used in matrimonial dissolution matters. However, that will vary by state, and a thorough understanding as the premise of value in those states is critical to arrive at a supportable conclusion. Some states have also introduced a value to holder premise of value. The value to the holder premise is based on the assumption that the business or business interest will not or cannot be sold, but the business owner will continue to derive benefits from that ownership subsequent to the dissolution of the marriage. Unlike fair market value that only considers the rights that could be transferred in a hypothetical sale, value to the holder considers attributes specific to the owner such as management rights, cash flow to the owner, and personal goodwill.
Fair value can be a bit vague and will have different meanings depending on the context of its use, whether in real estate appraisals, financial reporting, or litigation. Rarely, however, does fair value equate to fair market value.
For financial reporting, Accounting Standards Codification (ASC) Topic 820 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition is similar in many respects to fair market value defined in IRS Revenue Ruling 59-60.
However, the main difference is that fair market value considers a broad universe of hypothetical buyers and sellers, whereas fair value considers only “market participants.” Because these market participants may be in the most advantageous market, rather than the open, unrestricted market, value may be higher under this standard.
Fair value in litigation, such as shareholder dissention or oppression cases, tends to be defined by state statute—and these statutes vary from one jurisdiction to the next. In a typical dissention or oppression case, in lieu of selling the company, a corporation or shareholder may elect to purchase shares owned by a petitioning shareholder at the fair value of the shares.
Many courts have concluded that fair value is determined by first valuing the business as a whole, similar to fair market value, and then allocating that value to the petitioning shareholder in proportion to the shareholder’s ownership percentage, without automatically applying discounts for lack of control or lack of marketability.
Therefore, it is generally believed that fair value in litigation differs from fair market value in the consideration and application of discounts.
Strategic value, sometimes referred to as synergistic or investment value, is the value to a particular investor. This is unlike fair market value, which considers only hypothetical buyers and sellers. Under the strategic value standard, the buyer and seller are known; the specific motivations of that buyer or seller are considered; and synergistic benefits that may be achieved from the transaction may be quantified.
As you might imagine, strategic value could yield a significantly higher value than what may be determined under other standards. This is because of the benefits derived from cost savings and / or the premium paid to buy into a certain market space or remove a competitor.
Intrinsic value is the value that an investor considers, on the basis of an evaluation of available facts, to be the “true” or “real” value that will become the market value when other investors reach the same conclusion.1 In other words, value under other standards considers the price paid in the marketplace for a similar asset. Intrinsic value ignores the market and quantifies value strictly on financial metrics. Intrinsic value is used primarily by investment analysts and bankers to seek out the fundamental price of a publicly traded security.
Determining the appropriate standard to apply in the valuation of a business or business interest is critical, as the application of these standards can lead to very different value conclusions. The appropriate standard in any valuation engagement will ultimately depend on the purpose of the valuation, the specific facts and circumstances of the engagement, relevant federal and state statutes, and case law.
- BVR’s Glossary of Business Valuation Terms, Business Valuation Resources, LLC