What is Fair Market Value?
The Fair Market Value (FMV) refers to the current price that an interested buyer in the open market is willing to pay to purchase a certain asset.
Fair Market Value (FMV): Accounting Definition
The fair value of an asset is the price it’ll sell for in an open, competitive market whereby the seller and buyers all have adequate information with no external factors like time impacting their decision-making.
Fair Market Value Definition (Source: FEMA.gov)
How to Calculate Fair Market Value (Step-by-Step)
Two underlying assumptions for the fair value estimation are that the buyer and seller are both:
- Assumption #1 → Willfully Entering the Transaction
- Assumption #2 → Informed of Material Facts Regarding the Asset(s)
To provide specific examples, a seller in a distressed scenario divesting assets can often accept lower prices for the sake of convenience and time (i.e. a “fire sale”).
Despite the fact that the seller could likely receive a higher bid if given more time, quick sales of assets and receiving cash (i.e. urgent liquidity) could be prioritized above selling at the fair value of the asset.
For the second assumption, all material information of relevance should be shared on both sides. In other words, there should be no hidden information that could lead to a party underpaying or overpaying for the asset (e.g. defects).
On the date of transaction close, there should be a mutual agreement between the buyer and seller, who are both acting in their self-interests.
Fair Market Value vs. Intrinsic Value
- Intrinsic Value: Unlike the intrinsic value of an asset, which is estimated after evaluating its fundamental profile (e.g. cash flow generation, profitability), the fair value is a readily available price set by the market.
- Fair Market Value (FMV): The benefit of the fair market value is the fact that a real buyer and seller were willing to exchange at the given price, which makes the valuation “fair” and market-based. At the end of the day, the market sets the price, regardless of the amount of diligence and fundamental research supporting a different valuation.
Fair Market Value Examples (FMV): Real Estate Home Prices
As a simple example, if you’re selling a used car, the highest bid received from a buyer is the fair market value (FMV), as long as the two aforementioned criteria are sufficiently met.
Likewise, if you’re selling a house, your objective is to find a buyer willing to meet (or exceed) the asking price.
If the home is priced too high, it’ll sit on the market for a longer duration, but the probability of finding the highest-paying buyer increases (and vice versa).
Thus, estimating the fair market value of the home ahead of time can help in pricing the property correctly, so that the following two factors are balanced:
- Goal Purchase Offer Received
- Time Needed Until Closure
Note: Another related example is real estate taxes, as the amount of real estate taxes due is based on the fair value of the property.
FMV Examples: Stock Prices, M&A and Insurance Sector
- Stock Prices: Another example would be the share prices of publicly-traded companies, whereby the latest trading price (i.e. the most recent transaction) represents the fair value of the company’s stock. Since market pricing data is prone to containing anomalies (i.e. mistakes/errors, overbidding from irrational behavior), the average trading price for the day can be taken to arrive at a “normalized” share price.
- Mergers and Acquisitions (M&A): One of the more common use cases of the fair market value concept is in mergers and acquisitions (M&A), in which the purchased assets are often written up to their fair value as part of post-transaction purchase accounting. In effect, the value recorded on the books of the acquirer more accurately reflects the actual value of the asset, as opposed to the book value.
- Insurance Industry: Insurance companies frequently request the fair market value of the assets under coverage, as this impacts how much filed claims are worth. For the fair market value to be unbiased, an appraisal conducted by a third party is often done to value an asset without any conflict of interest.