Fair Value Vs. Fair Market Value: What's The Difference?
Posted by Valentiam Group on May 21, 2020
Every valuation employs a standard of value. Two terms that are frequently used—sometimes interchangeably—are fair value and fair market value.
Is fair value the same as fair market value (sometimes simply referred to as “market value”)? Although these terms sound like they’re describing the same thing, for valuation professionals, there is a significant difference between fair value vs. fair market value. In this article, we’ll define how these standards of value differ, and the applications where each is most appropriate.
Fair Value Vs. Fair Market Value
Although fair value and fair market value may align in some cases, from a legal perspective they have different meanings for the purposes of asset valuation.
Fair Market Value
Fair market value is the most widely accepted standard of value; the key word in the phrase is market. The IRS defines fair market value as “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 or relevant facts.” It reflects the price an asset (or business) would bring in a sale between a buyer and seller who are each apprised of market conditions and under no duress to sell or buy.
In a fair market value transaction, the fair value market price of the asset is set by the market; it is supported by the prices similar assets have brought in market transactions, and assumes that sellers and buyers are rational actors who would not substantially overpay (in the case of buyers) or underprice (in the case of sellers). Strategic or investment value is not considered in determining fair market value, as these metrics are not representative of value to a random buyer in the open market.
Fair market value is estimated by considering the following factors:
- Business type and history
- Economic outlook for the industry and overall economy
- Book value and financial status of the company
- Company earnings potential
- Dividend potential
- Value of goodwill and other intangibles
- Previous sales
- Market prices for comparable stocks
For business valuation purposes, fair market value is typically used in the following cases:
- Inheritance, estate, and gift transfers of assets
- IRS filings and other transfers governed by IRS rules
- Auction or open market sales of business entities
Fair market value is in part differentiated from fair value on the basis of discounts. Typically, fair market value takes into account these discounts:
- Marketability: This discount considers the lack of ability to rapidly convert an ownership stake to cash.
- Lack of control: A minority interest in the business impacts the amount of control the seller has over operating or financial decisions such as selling the business; this discount accounts for the lack of total control a seller has in selling the business, and the buyer will have after purchasing the business (assuming that the minority interest is not also purchased).
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Fair value is defined 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” by the Financial Accounting Standards Board’s Generally Accepted Accounting Practices (GAAP). That sounds similar to the IRS definition for fair market value, but in terms of valuation, there are differences.
As opposed to fair market value, fair value is a legal construct rather than a value set by the market. Fair value tends to be defined by statute—and these statutes vary from one jurisdiction to the next. (Tweet this!)
Typically, fair value does not take discounts for marketability or lack of control into consideration. It is often used when valuing businesses for these situations:
- Partner and shareholder disputes
- Shareholder buy/sell agreements dealing with internal share transfers
- Determining business value in marital dissolutions
Fair market value is typically the starting point for calculating fair value. Adjustments are then made in the interest of treating all parties fairly. In the case of minority shareholders who dissent from agreement to a merger or other transaction, the fair value standard prevents controlling shareholders from forcing minority shareholders to accept a lower price. By definition, the minority shareholders in such a transaction are not the “willing sellers” free from “compulsion to sell” envisioned by the fair market value standard; the fair value standard takes this into consideration to protect the interests of the minority shareholders.
Fair value is defined in many jurisdictions as the shareholder’s proportionate share of the fair market value of the business. Discounts for marketability or lack of control do not apply for obvious reasons: If the sale of the business has already been negotiated absent minority shareholders’ assent, the issue of marketability is moot, and dissenting minority shareholders are being bought out of their stake in the company. In addition, appreciation or depreciation in the business’ value arising from anticipation of the transaction are also commonly excluded in determining fair value.
Fair Value For Financial Reporting Purposes
For financial reporting, fair value is treated slightly differently. The definition is the same: “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.” Although the definition is the same, in financial reporting fair value derives not from the starting point of fair market value, as in cases of shareholder disputes where that value is established by activity in the open market.
GAAP only considers participants in the most advantageous market for reporting purposes, rather than the open, unrestricted market; typically this will result in a higher value. Valuation inputs under GAAP also have a tiered hierarchy, with the most weight given to established prices in active markets for identical assets and liabilities; a lower weight for comparable assets and liabilities; and the least weight to the company’s cash flow and other internal financial metrics.
Use Of Value Standards In Marital Dissolution Cases
The statutes governing valuation in divorce cases vary substantially from one jurisdiction to the next. Fair market value is the standard in many states, but some use the fair value standard similarly to the way it is used in dissenting shareholder cases.
In states that use the fair market value standard, adjustments may be necessary. States vary in terms of the treatment of goodwill; in some the value of a spouse’s personal goodwill is excluded from the marital estate, others exclude both personal and enterprise goodwill, and still others consider all goodwill to be part of the marital estate. In marital dissolution cases, it’s important to first review all statutes governing valuation in the specific jurisdiction before determining fair value vs. fair market value as the correct standard to use.
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Topics: Business valuation
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