In a business valuation, what is the standard of value? Isn’t the value of a business what it’s worth, regardless of the circumstances? In the context of a business valuation, the answer is no. By definition, the word “standard of value” implies that value is malleable and can change depending on one’s perspective or circumstances. Standards of value can essentially imply the same thing, but the underlying assumptions of the valuation change—they determine the value of a company given a set of conditions. In the context of a business valuation, the answer is no. By definition, the word “standard of value” implies that value is malleable and can change depending on one’s perspective or circumstances. Standards of value can essentially imply the same thing, but the underlying assumptions of the valuation change—they determine the value of a company given a set of conditions.
4 Standards Of Value & Definitions
The following are the four business valuation standards used to assess value:
- Fair market value: Business valuations using the FMV standard appraise value from the perspective of a disinterested third party, i.e., the rational investor. The fair market value standard attempts to assess how the market perceives the value of the business in question. The FMV standard looks at value from the standpoint of a rational third-party investor, such as someone purchasing stock. Fair market value is defined as “the price, expressed in 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” according to IRS Ruling 59-60.Reasonable market value Business values are the foundation for practically all property tax assessments and are used to determine value for transactions, investment choices, and legal proceedings. The fair market value (FMV) is frequently utilized in gift, estate, and income tax appraisals. Due to factors that are not relevant to a reasonable investor, the FMV criteria does not always offer an actual transactional (sell or purchase) value.
- Investment value: Sometimes referred to as strategic value, this standard of value pertains to a company’s value to a particular party or investor. The value of the business to a party such as a competitor, supplier, or customer is typically higher than it would be for a rational third-party investor due to the expectation of business synergies. Investment value varies depending on the value of the business to the specific purchaser; the business may well be more valuable to one competitor than to another, for example, Investment value is almost always the standard used to calculate value in a merger and acquisition (M&A) transaction. Essentially, it is a value calculation based on a bet that the combined entity will be more valuable and generate more profit. The premium paid for the business over and above fair market value of the tangible and intangible assets is considered goodwill.
- Fair value: This standard of value is usually used in an accounting or regulatory reporting context; while often it falls back on fair market value, the standards are not identical, Fair value as a legal norm, for example, may be used in shareholder disputes or marital dissolution cases, depending on the country. To guarantee that dissenting parties are not penalized for the lack of control that led to the conflict, the fair value would omit discounts for lack of marketability and lack of control. Furthermore, lack of control usually has an impact on value only when a party’s interest in the business is sold to a third party. The fair value standard ensures that oppressed minority shareholders receive the full value of their stake in the company, For accounting purposes, fair value is used for reporting asset values in alignment with Generally Accepted Accounting Practices (GAAP). In M&A transactions, the fair value standard is used to allocate purchase prices by the acquiring company.
- Liquidation value: The other standards of value are all going concern values, based on the premise that the business will continue operation, either independently or as a part of an acquiring company. A distressed business is obviously worth less than a desirable, healthy asset. As a result, liquidation value will look at value from the context of the business being terminated. The assumptions used to calculate liquidation value differ significantly from those used to calculate going concern value. Typically, the company will not be able to meet its operational expenses or debt commitments due to a lack of cash flow, and it will risk bankruptcy or dissolution. Distressed businesses, on the other hand, may have significant intellectual property (IP). Customers, patents, trademarks, and copyrights are all examples of IP value. The assets’ value will be determined by a rapid sale and a piecemeal disposition. It’s also possible that the assets will be worthless because the cost of removing or transferring them is often larger than the real value.
Depending on the circumstances, each of these four business valuation standards will yield a different figure to represent the value of the company. This variation reflects value in many contexts depending on which standard is used, and it tries to reflect value as a function of circumstance or to a specific owner or purchaser.
Fair market value may be insufficient to reflect value in cases of shareholder disputes where the interests of an oppressed minority would be devalued by the application of discounts for lack of control and marketability, just as liquidation value would be an inappropriate metric to apply to a going concern to establish value for an M&A transaction. The various standards of value enable for these differences in circumstance to be taken into consideration in order to arrive at a more realistic value for the firm in each case.
Business valuation experts are well-versed in the application of each of the value standards, as well as the context in which they should be used. The purpose of the valuation is the first question a valuation specialist will try to address in a business valuation. A skilled appraiser will determine the suitable standard of value for the conditions at hand by applying the rules of thumb for business valuation.
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