Understanding the Various Standards of Value

Understanding the Various Standards of Value

In order to be familiar and invest in the companies that interest us, it is useful to go through their financial or business valuation reports. More often than not, we will come across some unfamiliar and confusing terms. One such category of financial term would be the standards of value of a company.

Standard of value is the specific identification of a type of value that is being utilized in a particular business transaction or financial engagement. Under different conditions, the standard of value may carry different meanings to the parties involved. For this reason, we need to be clear in defining the various situations. At the end of this article, readers will be able to differentiate various standards of value and how it can affect their investment decisions. Listed below are some explanations for the various standards of value of a company:

• Fair Market value

In general, fair market value is being defined as ‘the cash or cash equivalent price at which an asset will change hands between a willing seller and a willing buyer when both are adequately informed of the relevant facts on the asset condition and at the prevalent economic and market conditions’. This is the most widely accepted standard of value. Usually, the seller is at the advantage of having more relevant information; therefore, to fulfil the definition of fair market value, the seller is required to disclose all relevant information to the potential buyers.

Another assumption of the definition of fair market value is that the property or asset is being exposed to the market for a reasonable period of time to seek potential buyers. If the seller is under pressure to dispose of the asset at a very short period of time, then the price at which the asset change hands will not be considered as fair market value.

The terms ‘market value’ and ‘cash value’ are sometimes used interchangeably with fair market value.

• Investment value

This is buyer’s perspective of the value of a property or asset. It is based on the investment objective and return expectation. Usually it is calculated by discounting the future income stream or expected return. The investment value is unique to each individual buyer and may be different from the fair market value due to the differences in estimating future earning power of the asset and the degree of risk of investing in it.

• Intrinsic value

It is the price of a company that the owner is willing to sell, which should reflect all the facts, including the value of its assets, earnings, dividends as well as potential future prospects. In stock investment, the concept behind the ‘intrinsic value’ is basically the value that can be taken out from a business. Intrinsic value is different from investment value in that it is being driven by an analytical judgement of value based on characteristics of the investment rather than the expectations or objectives unique to a particular investor. However, it is a subjective number as the investor or analyst will need to use his own assumptions and judgement to estimate the intrinsic value of a company. That is the reason why we often see different analysts publishing different intrinsic values of the same company.

• Liquidation value

This is the net value of a company or business if its operation is terminated and all the tangible and intangible assets are being sold off. Under normal circumstances, we will not calculate a liquidation value unless the company is in financial distress or for any other reasons that the company owner decides to close down the business. There are two types of liquidation value. In an orderly liquidation, the assets are being offered for sale for a reasonable period of time in an attempt to obtain the best price; whereas in a forced liquidation, the assets are being sold off at the shortest possible period of time, usually in an auction sale. The value obtained from a forced liquidation is normally lower than an orderly liquidation due to the time limitation.

• Book value

Book value is an accounting term, measuring the sum of assets, after netting of the depreciation, amortization and the liability accounts in the balance sheet. Sometimes it can also be called as the owner’s equity, net worth or shareholders’ equity as it is the total cost that the owner or shareholders have invested in the company. The longer an asset or liability is being placed in the book, the less likely is the book value of the asset to be closed to the fair market value of the asset. Therefore, under normal economic situation, if a company has been existence for a long time, it is unlikely for the fair market value of the company to be lower than its book value unless the company is not doing well or the economy is on a down trend.

It is very important for investors to understand the standard of value within the context of any valuation, be it a business appraisal or financial reporting. This is to avoid misinterpretation of reports which may affect investment decisions.

© Securities Industry Development Corporation 2010. 

*Note: This article was written by Mr Ooi Kok Hwa, holder of the Capital Markets Services Representative’s License to carry on the business of investment advice under the Capital Markets and Services Act 2007. The information provided in this article is only for educational purposes and reflects the market conditions at a specified point in time, which may lapse and affect the relevance of this article. This article does not necessarily represent the official view of Securities Industry Development Corporation and should not be used as a substitute for legal or other professional advice.