What Are the Different Bases of Valuation?

A basis of valuation is the set of assumptions and conditions under which the economic worth of an asset, liability, or business is determined. The selection of a specific basis is a foundational step in the appraisal process, as it dictates which valuation methods are appropriate and influences the final value conclusion. Different circumstances require different perspectives on value. For instance, the value of an asset for insurance purposes might differ from its value in a forced sale. By first establishing the basis, a professional ensures the subsequent financial analysis is appropriate for its intended use, aligning the valuation’s purpose with its methodology and outcome.

Common Premises of Value

Fair Market Value (FMV) is a widely recognized standard, particularly in tax-related matters. As defined in IRS Revenue Ruling 59-60, it is the price at which property would change hands between a hypothetical willing buyer and a willing seller, neither being under any compulsion to act and both having reasonable knowledge of relevant facts. This standard assumes a theoretical, open-market transaction, not tied to any specific buyer or seller.

A related premise is Fair Value, central to financial reporting under U.S. Generally Accepted Accounting Principles (GAAP). Accounting Standards Codification (ASC) Topic 820 defines it as the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Unlike FMV, its focus is on an “exit price” from the perspective of market participants to ensure consistency in financial statements.

Investment Value represents the worth of an asset to a specific investor, based on their individual requirements and expectations. This value is subjective and can differ from FMV because it may account for unique synergies a particular buyer could realize. For example, a competitor might assign a higher investment value to a business if acquiring it would reduce their operational costs or provide access to a new customer base.

Liquidation Value is the net cash that could be realized if a business terminates and its assets are sold individually. This premise is divided into two scenarios. Orderly liquidation assumes assets are sold over a reasonable period to maximize proceeds. In contrast, forced liquidation implies assets are sold as quickly as possible, such as at an auction, which often results in a lower value.

Contextual Application of Valuation Bases

For most federal and state tax purposes, Fair Market Value is the mandated standard. This includes valuations for estate taxes, gift taxes, and determining the value of property donated to a charity. The IRS uses this standard to ensure a consistent measure for tax compliance.

For financial reporting, Fair Value is the required premise for public companies and many private entities under GAAP. Certain assets and liabilities must be reported at their fair value on financial statements. This is common in a business combination, where the acquirer must allocate the purchase price to the acquired assets and liabilities, or when testing for goodwill impairment.

During mergers and acquisitions (M&A), a seller might use FMV to establish a baseline price. A strategic buyer, however, will likely determine their offer price based on Investment Value. This approach allows them to factor in unique financial benefits and synergies they expect from the combination, which can justify paying a premium over FMV.

When a company faces financial distress like bankruptcy or restructuring, Liquidation Value becomes the relevant basis. The concern is determining the money available to repay creditors if operations cease and assets are sold. This value helps courts and stakeholders understand the potential recovery in a worst-case scenario.

Legal disputes, such as shareholder disagreements or divorce proceedings, often require a valuation. The appropriate basis of value is determined by the laws or legal precedents of the specific jurisdiction. While FMV is frequently used, courts may modify the standard, for instance, by disallowing discounts that could unfairly penalize a minority shareholder.

Information Required to Establish Value

A thorough analysis requires collecting specific corporate and financial documents. This includes organizational records such as the articles of incorporation, bylaws, and any shareholder or partnership agreements. At least three to five years of historical financial statements are also necessary to understand past performance.

Financial projections or budgets prepared by management are also needed. These forecasts provide insight into the company’s expectations for future performance and help a valuator understand potential earnings and cash flow.

A detailed understanding of what the company owns and owes is also required. This involves obtaining schedules that list all tangible assets, like real estate and equipment, and their condition. A schedule of all intangible assets, such as patents and trademarks, is also needed, as is a list of all outstanding debts and liabilities.

Non-financial information provides context to the numbers. This includes a business history, biographical information on key personnel, and lists of major customers and suppliers. An analysis of the company’s industry and its competitive position is also performed to assess external risks and opportunities.