In business valuations, the Standard of Value and the Premise of Value are two important concepts that must be understood in order to accurately determine the worth of a company. The Standard of Value refers to the general level of value that is being sought in a valuation, while the Premise of Value refers to the specific circumstances under which the valuation is being performed.
The Standard of Value
The Standard of Value is an overarching term that refers to the value being sought in a valuation. There are three commonly recognized standards of value in the business appraisal industry: fair market value, fair value, and investment value:
1. Fair Market Value
Fair Market Value (FMV) is the most widely used standard of value and is defined as the price that a property would sell for in a competitive and open market between a willing buyer and a willing seller, both of whom are knowledgeable and acting without undue pressure. This standard of value is often used in estate planning, divorce settlements, and other legal proceedings.
2. Fair Value
Fair Value (FV) is the value of the business immediately before the company action to which a dissenter objects, excluding any change in value in anticipation of the corporate action. This value typically is similar to FMV without any discounts for lack of marketability or control and is often seen in valuations regarding divorce and marital dissolution.
3. Investment Value
Investment Value refers to the value of an asset to a specific investor based on their individual investment goals, risk tolerance, and investment strategy. This standard of value is typically used in the context of a buy-side or sell-side engagement, where the valuation is being performed for a specific buyer or seller.
Keep in mind that there can be a fourth Standard of Value which is the Intrinsic value which refers to the underlying value of an asset, independent of its market price. This standard of value is often used in the context of value investing and is based on an analysis of the underlying financial and operational characteristics of the business.
The Premise of Value
The Premise of Value, on the other hand, refers to the specific circumstances under which the valuation is being performed. There are four commonly recognized Premises of Value in the business appraisal industry: net book value, going-concern value, liquidation value, and replacement value.
1. Net Book Value
This is the difference between the total assets (net of accumulated depreciation and amortization) and total liabilities as they appear on the company’s balance sheet. This value is synonymous with the book value of equity.
2. Going Concern Value
This refers to the value of a business as an ongoing operation. This premise of value assumes that the business will continue to operate in the future and will generate future cash flows. Going concern value is typically used in the context of a sale or acquisition, where the valuation is being performed for a buyer who intends to continue operating the business.
3. Liquidation value
This refers to the value of a business if it were to be immediately liquidated. This premise of value assumes that the business will cease operations and that its assets will be sold for the highest possible price. Liquidation value is often used in the context of a bankruptcy or other financial restructuring, where the valuation is being performed for the benefit of creditors.
4. Replacement Value
This refers to the current cost of a similar new asset having the nearest equivalent utility to the asset being value.
Conclusion
Understanding the difference between the Standard of Value and the Premise of Value is critical to accurately determining the worth of a business. While the Standard of Value refers to the general level of value being sought in a valuation, the Premise of Value refers to the specific circumstances under which the valuation is being performed. By considering both the Standard of Value and the Premise of Value, business owners and investors can ensure that they receive a comprehensive and accurate valuation of their company.