Finding the appropriate valuation standard

Value isn’t static and can change depending on the purpose of the valuation. The three most common standards of value are: fair market, investment and fair.

Fair market value is the price for which the universe of buyers and sellers agree to exchange a business interest. Investment value, sometimes called strategic value, is the value unique to a particular buyer and seller, while fair value is defined by law. Usually, valuators will arrive at a different value for each.

Considering fair market value

Treasury department regulations define 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 of relevant facts.
• When estimating the fair market value of a business, it’s important to remember that there are two sides to the coin: a willing buyer and a willing seller. Too many well-documented valuation reports focus exclusively on what the buyer would pay for a business.
• When a valuator doesn’t consider what a seller, under no compulsion to sell, would accept for his or her business interest, he or she invariably undervalues the business interest. After all, a third-party buyer is hoping to find a bargain and will negotiate the lowest price possible. The seller, on the other hand, wants to get the most from his or her investment.
• It’s the compromise between the bid price (the buyer’s position) and the ask price (the seller’s position) that establishes a company’s fair market value. Determining a fair market value to which both buyer and seller will agree involves finding a starting point that reflects future earnings, considers existing conditions not yet reflected in the financial results, and eliminates unusual events and transactions. Without it, consensus and a signed contract will be hard to accomplish. In fact, few businesses sell for fair market value.

Determining investment value

Investment value — the value unique to one party — is the preferred standard in business combinations. Investment value considers a specific investor’s expectations, risks, tax situation and synergies.

When quantifying investment value, appraisers frequently focus on the discounted cash flow method over other valuation techniques. Key inputs include management’s projected cash flows, expected growth rates and the combined entity’s expected cost of capital.

Valuing synergy

In successful business combinations, the value of the combined entity exceeds the sum of the parts operating independently. This incremental value commonly is referred to as “synergy.”

Fair market value is a logical starting point for valuing synergy, but rarely an ending point. Instead, sellers hold out for strategic buyers, who often are willing to pay a premium for control attributes and synergy.

Put simply, synergy is the difference between 1) the sum of the companies’ fair market values without pursuing the business combination, and 2) the investment, or strategic, value of the combined entity.

Finding fair value

In many ways, fair value for reporting purposes is similar to fair market value as defined in IRS Revenue Ruling 59-60. Both standards of value assume an exchange price that involves hypothetical buyers and sellers with both parties knowledgeable, unrelated, and able and willing to transact. In addition, buyer-specific synergies are excluded from the company’s fair value.

There are some subtle differences between the two terms. Fair value may contain some elements of investment value. For instance, in September 2006 Financial Accounting Standards Board (FASB) Statement No. 157, Fair Value Measurements (FASB 157), introduced the concept of “market participants,” which refers to buyers and sellers in the principal (or most advantageous) market for the asset or liability.

Thus, the pool of market participants in a hypothetical fair value transaction may be smaller than the entire “universe of potential buyers and sellers” considered when estimating fair market value. The principal market is also entity-specific and may vary from company to company.

Minimizing confusion

Identifying the appropriate valuation standard up front can minimize confusion down the road. Buy-sell agreements and buy-back provisions, for example, should directly state the desired valuation standard. The goal, of course, is to arrive at a reasonable and supportable value conclusion in light of all the surrounding facts and circumstances.

Sidebar: The synergy trap

Quantifying synergy is no easy task. It requires complex, subjective financial analysis. One key reason for failed business combinations is overvalued synergy. Management’s previous budgeting track record, past merger-and-acquisition experience, and familiarity with the target’s market and industry (if different from the acquirer’s business) can affect the reliability of management’s forecasts for the combined entity.

In these cases appraisers often play devil’s advocate, questioning whether management considered factors that might diminish potential synergies. For example, does management allow for a reasonable assimilation period before synergies begin to affect projected cash flows? Does management consider postdeal assimilation costs — such as incongruent corporate cultures or incompatible information technology systems — that offset potential synergies?