Business Valuation: How value is defined.
Last time we discussed the assorted reasons a business is valued. Today we will talk about another especially important key piece. How value is defined for the engagement. It is not enough to say, “we are valuing a business.” What are the rules by which we are valuing?
According to Webster’s dictionary, the definition of “value” is “fair return or equivalent in goods, services, or money for something exchanged.” In business valuation there are four (4) main standards of value most often used:
Fair Market Value (FMV),
Fair Value (FV),
Investment Value, and
Intrinsic Value.
Fair Market Value: The most used standard of value is defined by the International Glossary of Business Valuation Terms as:
“[T]he price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
One of the first items to note is that this definition assumes a hypothetical buyer and seller. That means that we are not considering the specific seller or buyer's individual opinions or assumptions. The next item to note is that the hypothetical buyer and seller are unrestricted, not under force (compulsion), and have reasonable knowledge. In short, both buyer and seller understand the business and circumstances of the business, industry, and economy as of the date of value.
These items should be the starting point as a valuator determines the hypothetical type of buyer (C Corporation, S Corporation, Individual, etc.). From this point forward the valuator uses this “perspective” when reviewing the company’s financials and making adjustments.
Fair Value: There is no one size fits all definition for Fair Value. In business valuation, the context varies state to state based on prior case law. For example, dissenting shareholder cases, corporate dissolution cases, and in some states divorce. The fundamental difference between Fair Value and Fair Market Value is that FMV implies a “willing seller.” In Fair Value cases, most courts are concerned with the concept of fairness, resulting in the valuations intended purposes to be “equitable” for the disadvantaged party.
One other instance where the concept of Fair Value is seen is in Financial Reporting. The Financial Accounting Standards Board standard FAS 157 defines fair value as “the price that would be received when an asset is sold or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition differs from FMV in that it considers market participants and does not eliminate synergies.
Investment Value: This is the value to a particular buyer as compared to a hypothetical willing buyer. Often used in Mergers & Acquisitions, the value allows for a specific investor’s investment criteria, assumptions, and synergies to be accounted for in arriving at the value.
Some courts in divorce cases have adopted a similar standard of value, as many times there is no “willing buyer” at the time of the divorce proceedings. This concept is often referred to as “value to the owner.” This standard of value should be reviewed on a case by case, court, and locality basis.
Intrinsic Value: Financial analysts most often use this value. The term is defined by the International Glossary of Business Valuation Terms as:
“The value that an investor considers, on the basis of an evaluation or available facts, to be the “true” or “real” value that will become market value when other investors reach the same conclusion…”
The intrinsic value is considered to be the value of a stock based on the facts and circumstances ignoring the fluctuations of the stock market.
Why does the standard of value matter?
Once the purpose is decided, the standard is the next step in the valuation process. Generally, from these two (2) first steps the rest of the valuation “viewpoint” and assumptions are set. Working with someone who understands the diverse options and how they guide the valuation process will help the end user receive a value and a report that means something and supplies actionable value.
Have questions or need help?
I’m Gregory M. Clark, MSA, CPA, CVA, MAFF of GMC & Company. I help attorney’s and their clients in litigation matters with business valuation, litigation support, forensic accounting, and consulting. If you have a shareholder dispute, or are going through a divorce and need a business valuation or forensic services, let’s talk! Call us at 219-554-9700 or email us at info@gmcandco.com.
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