How to Find Fair Market Value
"Fair Market Value" is defined as the amount at which property would change hands between a willing buyer and a willing seller, each having reasonable knowledge of relevant facts and neither being under any compulsion to buy or sell. This concept of value is supported by definitions enumerated by the IRS, specifically in Revenue Ruling 59-60. It has also been a focal point of numerous court decisions dealing with fair market value. There are three recognized approaches to calculating fair market value--the income approach, the cost approach and the market approach. Each approach has different methods that can be employed.
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Instructions
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Understand the basis for use of the income approach. The income approach estimates value by calculating the present worth of the future income expected to be derived from the use or ownership of an asset. Applicable methods used in the income approach are the discounted cash flow method, the capitalization of earnings method and the excess earnings method.
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Decide if methods under the income approach should be used to calculate fair market value. The discounted cash flow method is used when a company exhibits fluctuations in its income stream. The discounted cash flow method uses historical earnings to create projections of cash flow until the earnings stabilize. The earnings are then discounted to present value to arrive at fair market value. The capitalization of earnings method is used when a company has a steady income stream. The income is adjusted for nonrecurring items, noncompulsory expenses and noncash expenses such as depreciation. This normalized income is then capitalized using the inverse of an applicable discount rate, or the capitalization rate, to calculate fair market value. The excess earnings method calculates the goodwill of a company and adds the value of the net tangible assets to calculate fair market value. The excess earnings method is generally used for the valuation of professional practices.
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Understand the basis for use of the cost approach. The cost approach involves an estimation of the cost of replacing an asset with one of similar utility.
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Decide if the net asset value method under the cost approach should be used to calculate fair market value. The net asset method of valuation calculates the current market value of all assets and liabilities of the company. This method may involve hiring a real estate appraiser or machinery and equipment appraiser to accurately ascertain the market value of certain assets. The difference between the market value of the assets and liabilities is the fair market value. The cost approach is generally utilized to value businesses that are asset intensive, such as real estate or investment holding companies or businesses undergoing liquidation proceedings.
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Understand the basis for use of the market approach. The market approach estimates the value of an asset based on recent sales of similar property. The guideline company method and market transactions method are both market approaches. These approaches involve researching companies and transactions in a similar line of business, with similar product revenues and profit margins to the company being valued. Ratio analysis is then completed to draw comparisons between the guideline companies or market transactions and the company being valued to determine an appropriate market multiple. Market multiples under both the guideline company method and the market transaction method include price to revenue, price to earnings and price to owner's discretionary cash flow.
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Tips & Warnings
To determine fair market value of a company, consider using a valuation expert. The American Institute of Certified Public Accountants has a listing of CPAs holding the ABV (Accredited in Business Valuation) credential. Additionally, the American Society of Appraisers and the National Association of Certified Valuation Analysts have credentials to distinguish certain levels of expertise in the area of business valuation.
