How to Determine the Fair Value of a Business
Statement of Financial Accounting Standards Number 157, which was issued by the Financial Accounting Standards Board in September 2006, states the definition of fair value as follows: "Fair value is 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." Fair value is a market-driven value. Businesses that hold marketable securities will find themselves in need of fair-value valuations of those assets if financial statements are prepared.
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Instructions
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Determine the measurement date. The measurement date is the date market information will be used to determine the fair value.
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Determine the premise for the highest and best use for the asset being valued based on the market participants. If valuing a liability, the exit price right before the liability is discounted for duress factors, or transaction price at initial recognition, will be determined.
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Calculate fair value using recognized valuation approaches. Each valuation approach has several different methods that can be used to quantify fair value. The choice of method is dependent on the type of business being valued, the availability of industry data and the business' earnings history.
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Use the market approach if sufficient market data exists for recent sales of similar, comparable assets. Apply market multiples when using the market approach. If market multiples do not exist, use Matrix Pricing which relies on a security's relationship to other market traded and quoted securities.
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Apply a recognized valuation method under the income approach. The income approach method discounts future earnings or cash flow to a present value. While these methods require an understanding of option pricing models, online calculators that ask you to enter the stock price, strike price, volatility, interest rate and other pertinent factors can be used in simple cases.
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Determine the replacement cost of an asset when using the cost approach. Replacement cost considers obsolescence. Obsolescence is similar to the idea of depreciation. However, obsolescence also incorporates physical deterioration as well as outdated functional and economic features.
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Review the valuation to ensure that information regarding quoted prices in active markets has been included in the analysis. Quoted prices are the best indication of fair value and should be used in every case data exists.
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Reconcile the calculated fair value. Judgment is crucial to this step, however calculating an average or weighted average of the fair values is a good starting point.
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