Fair Value vs. Market Value

Let's say you need to get something valued — an asset, property, shares of stock or a company. The valuer typically will apply a measure called "fair value" or "fair market value" to achieve a sensible sales price. These terms look identical but they are very different. The reason they are different relates to origination as well as when and how they are used.

Fair Value vs. Market Value
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Fair Market Value Defined

Fair market value is the most commonly used and accepted measure of value, which is not surprising when you realize that it's the taxman's measure. The Internal Revenue Service defines it like this: "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." Basically, it's the objective number you'd expect to see if you put your asset for sale in the marketplace.

Fair Value Defined

Fair value is the standard measure of valuation under the Generally Accepted Accounting Principles, a common set of accounting rules used for financial reporting. The Financial Accounting Standards Board defines it like this: "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." If that sounds hazy, it's because it is. To add to the confusion, most states define fair value in specific situations such as divorce proceedings, and that definition might mean something entirely different than when it's used for financial reporting.

The Key Word Is "Market"

Fair market value is the price you'd get if a completely fictional seller and buyer bought and sold something in the marketplace. The key word here is "market." Using the market as a foundation for valuation assumes that both parties are willing, reasonable and have full knowledge of the facts; that neither party is restricted from trading or holds more bargaining chips than the other. It's an objective and entirely theoretical valuation. Appraisers use fair market value to value assets, estates, gift and inheritance transactions, businesses and real estate for sale and tax purposes.

Objective vs. Subjective

Compare fair market value to fair value, which takes into account some grass root facts about a specific buyer or seller. Suppose, for example, that you're valuing business interests in a merger situation. The minority shareholders here are neither "fictional" nor "willing," since they may feel squeezed out by the merger. These shareholders have less control than larger shareholders and their business interests may be less marketable — both of these limitations tend to reduce the price in the open market. A fair value measure would recognize these facts and protect the minority shareholders from being forced to accept an unfairly discounted price. Appraisers tend to use fair value when valuing publicly traded stock and in other personalized circumstances like divorce proceedings.

Which Do You Choose?

Most times, you don't have a choice about which valuation method to use. Contracts, such as shareholder agreements, might specify which valuation method you should apply, and state laws typically have something to say about how fair value is used. Ultimately, you'll need to work with a valuer who can add some much-needed context.

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