Seeing Double ? The many faces of Value and why you need to choose them thoughtfully
A good valuer is able bring intelligent precision into something inherently imprecise. Let's start with what is the Value that you actually mean.
When we value an asset, we need to be thoughtful about what is the definition of Value. Getting the definition of Value clear and cleared is the first step in ensuring the valuation methodology and results are robust. It is understandable if the layperson has an abstract notion of value. However, professional valuers have a duty to clients (including the Courts) to be as precise as possible. Nothing could be worse than being accused of having sloppy logic under cross-examination.
Imagine we are now in a divebell bobbing on the ocean waters. Let's dive in to reach the bottom of one of the core pillars of valuation.
The Standard of Value in the Valuation of Assets
Different authorities name and define the standard of Value differently. These differences can be nuanced or stark. These authorities include the Courts, the tax authorities, the accounting standards setters and the valuation standards setters. Good grief! Is it that we can only agree to disagree?
Based on our extensive research, there are broadly six standards of Value.
1) Fair Market Value - This is probably the most commonly known and sometimes referred to as the default value standard.
The general definition of fair market value is almost universally accepted as "the cash, or cash-equivalent, price at which the property would change hands between a willing buyer and a willing seller, both being adequately informed of the relevant facts and neither being compelled to buy or to sell."
In this definition, we have to agree that:
a) The "market" means all potential and sellers of like assets (e.g. businesses). It should not be confined to a specific buyer or seller facing a specific situation.
b) There is no forced sale of the asset. The asset will be marketed for a reasonable period of time.
c) The prevailing economic and industry conditions will be considered at the valuation date.
Nobody knows for sure who first came up with this definition. For example, the Inland Revenue Service in the United States defines FMV as:
"The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts" (IRS Revenue Ruling 59-60).
The US tax man's definition of FMV seems close enough to the generally accepted definition. But wait, there's no mention of cash or cash-equivalent price...
Moving along, the Canada Revenue Agency Act (No. 89-3) defines FMV as:
"The highest price, expressed in terms of money, that a property would bring, in an open and unrestricted market, between a willing buyer and a willing seller who are both knowledgeable, informed, and, prudent, and who are acting independently of each other"
Now, the CRA mentions "the highest price" which is nowhere found in the IRS's definition.
In the UK, the tax authorities (HMRC) interestingly do not use the term Fair Market Value but Market Value for tax reporting. The UK HMRC definition of Market Value is
"The price which the property might reasonably be expected to fetch if sold in the open market at that time, but that price shall not be assumed to be reduced on the grounds that the whole property is to be placed on the market at one and the same time."
It is interesting to see the divergence and similarities in definitions of what is Fair Market Value. The UK HMRC in fact omitted the word "fair" but the substance of Market Value definition is very similar to the IRS and CRA's.
2) Fair Value - This is the bazooka contribution from the accounting standard setters as the financial reporting world moves towards fair value measurement. International Financial Reporting Standard 13 (Fair Value Measurement) 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."
For financial reporting purposes, over 130 countries require or permit the use of International Accounting Standards published by the International Accounting Standards Board. In addition, the Financial Accounting Standards Board in the United States uses the same definition of Fair Value
in Topic 820.
The attentive reader will see that the accounting definition of Fair Value is quite different from the definition of FMV, and also not the easiest to understand. IFRS 13 happens to have about 100 poetic paragraphs on the application of fair value (FUN!).
Moving along, the International Monetary Fund and OECD's definition of Fair Value are quite different from the accountants. I guess economists and accountants do have different world views afterall.
"The fair value of a financial asset or liability refers to the value that approximates the value that would arise from a market transaction between unrelated parties."
Having covered the definitions of Fair Market Value and Fair Value, courtesy from the tax authorities and the accountants, let's bring onto the stage the valuers :). The International Valuation Standards Council also have their own defnitions of Value. The IVSC however does not use the terms Fair Market Value nor Fair Value in the valuation standards. Instead they use Market Value.
3) Market Value - IVSC defines it as
"Market Value is the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion."
This definition appears to be a hybrid of the definitions of Fair Market Value and Fair Value. In addition, IVSC introduces the concept of "highest and best use" which means the asset will be used that maximises its potential which is legal and financially feasible.
The definitions of Fair Market Value, Fair Value and Market Value appear to have the core similarities of:
a) Many knowledgeable and free-to-act buyers and sellers in the open market,
b) No distressed situation,
4) Liquidation Value - IVSC defines it as:
"The amount that would be realised when an asset or group of assets are sold on a piecemeal basis. Liquidation Value should take into account the costs of getting the assets into saleable condition as well
as those of the disposal activity. Liquidation Value can be determined under either an orderly sale or distressed sale basis.
This brings us to the other end of the spectrum which is for businesses undergoing a liquidation. We are of the opinion that as long as a financially weak business does not undergo liquidation, we should be using either the Fair Market Value, Fair Value or Market Value definitions and not liquidation value.
We were not able to find other authoritative bodies other than IVSC which use and define the term Liquidation Value.
Still doing ok in the divebell ? We are deep enough where sunlight no longer reaches us. In the abyss, we will introduce two final concepts of value which are not so frequently used but still important under certain situations.
5) Equitable Value - IVSC defines it as:
"The estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties. Equitable Value requires the assessment of the price that is fair between two specific, identified parties considering the respective advantages or disadvantages that each will gain from the transaction.
For the first time, there is a standard of value where there are just two specific and identified parties. This is fundamentally different from the previous standards of value which were based on open markets and many buyers and sellers.
We are not certain if the concept of Equity Value would gain mainstream acceptance. It is theoretically attractive because often there are transactions just between two identified parties. IVSC did explain that Equity Value could equate Market Value but the Valuer should consider specific issues which would result in a difference. The concept of Equity Value is new, being introduced by IVSC in 2007. This concept is still being researched by economists and accounting experts.
6) Investment Value - IVSC defines it as
"The value of an asset to a particular owner or prospective owner for individual investment or operational objectives"
"Investment Value is an entity-specific basis of value. Although the value of an asset to the owner may be the same as the amount that could be realised from its sale to another party, this basis of value reflects the benefits received by an entity from holding the asset and, therefore, does not involve
a presumed exchange."
"Investment Value reflects the circumstances and financial objectives of the entity for which the valuation is being produced. It is often used for measuring investment performance."
This is also a relative new concept which has yet to gain mainstream acceptance.
Our Concluding Thoughts
It is critical that we correct define the standard of value before we value any asset. As we have seen, the word Value means different things to different people. The professional valuer will have to consider all factors and ask the important questions which will allow him to agree on the correct standard of value to use. Never assume different people have the same interpretation of value. This is especially so in a court-ordered buyout of shareholders.
When driving to a new place, wouldn't you want to turn on Google Maps first?
Similarly, when you want to get to the right valuation outcome, wouldn't you want to use the correct standard of value first?