Know Your Valuation Standards

There are all types of scenarios where people want or need to know what something is worth, i.e. the value. This valuation question arises in the world of business as well as the personal lives of individuals. This brief is an attempt to clarify certain pragmatic aspects of Valuation theory.

All fields of human endeavor are grounded in a body of theory. The science of Valuation is no exception to this rule. Like all sciences, the science of Valuation never stops evolving, and is built on certain standards that form the foundation for the science. The standards that are being discussed here are referred to as the “Standards of Value”.

There are three standards of value recognized in valuation theory: Fair Market Value, Fair Value, and Strategic/Investment Value. We will discuss two of those standards, and ignore the “Fair Value” standard. The results of a valuation, a “conclusion of value”, is materially affected by which of these three standards are adopted. There is no doubt that the choice of a standard of value is critical and is one of the first decisions that needs to be made in a properly executed valuation process.

One standard of value, “Fair Market Value”, is utilized in the majority of valuations. Most accredited valuation analysts refer to a IRS Revenue Ruling (59-60) for the definition of this term: ‘The price at which the property would change hands between a willing buyer and a 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”. The willing buyer and willing seller are hypothetical, not the actual current owner nor the buyer. The Fair Market Value is therefore derived without consideration to what could happen to a business or property once in the hands of the buyer. This pervasive fact should be very carefully understood by all parties.

The next standard of value “Strategic/Investment Value” is much different, and yields a different result. In many scenarios, it is clear that the buyer of a property or business fully intends to create and/or realize synergies as a result of a purchase. The buyer could also just simply be a far better manager and therefore achieve better results. In this assumed strategic scenario, the buyer is known, not hypothetical. Since the buyer often expects to achieve far better results, the “conclusion of value” of the property or business would be materially higher. Of course the alternative is also possible: the buyer could be a much worse manager or unable to maintain the customer relations that the seller had established. Buying a physician practice and then losing many of the established panel of patients would be an example of such an outcome.

Stepping back from these two contrasting standards, one could wonder what difference it really makes in practice. Even when a valuation is performed based on the Fair Market Value standard of value (and most of them are) the buyer and the seller should still understand what the conclusion of value truly represents, and what it does not include. An informed buyer would never want to pay the value resulting from a Strategic/Investment approach, else they would be paying full price for all of the synergies and other improvements they expect to achieve, leaving nothing to gain from the purchase. The seller however should want to understand whether their property or business is far more valuable in the hands of the buyer. In practice, the conclusion of value under the Fair Market Value standard, should be nothing more than a starting point. Both the buyer and the seller should negotiate accordingly.

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