Appraisal Review #4: Definitions of Fair Market Value

This is the fourth post in a series about appraisal review in its broadest sense.

  • In the first post, we provided an overview suggesting that appraisal review is more than simply reading another appraiser’s work and attempting to reach an opinion regarding it. We have to know valuation theory and practice well to accomplish an effective review of the work of others or our own work.
  • In the second post, we discussed the definitional concepts of the standard of value and the premise of value and introduced the levels of value.
  • And in the third post, we discussed the conceptual levels of value in some depth, indicating that the different “levels” are caused by differing perceptions of expected cash flow, growth and risk of market participants and hypothetical investors at the various levels.

Now, in this fourth post, we discuss definitions of fair market value. Fair market value is the most common standard of value employed by business appraisers. It is the standard for gift and estate tax and charitable giving matters as well as for many other appraisal requirements involving the federal government. And it is the most frequently used standard of value in buy-sell agreements and in other business arrangements requiring opinions of value. Despite its frequent employment, it is my observation that fair market value is not nearly as well-understood by business appraisers, attorneys, and courts as it should be.

Definitions of Fair Market Value

Fair market value is known as a “willing buyer” and “willing seller” concept. It is the logical framework through which an effort is made to determine the price at which the equity ownership interests would trade under the presumption that an active market exists for the interest(s). Fair market value is not a defined term in USPAP. However, the Internal Revenue Service’s Revenue Ruling 59-60, which provides guidelines for the valuation of closely held companies, presents a working definition of fair market value:

2.2   Section 20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property. (emphasis added)

Several characteristics of the definition of fair market value are highlighted in the definition above. They are important characteristics and have significant implications regarding how business appraisers and courts should interpret this important standard of value. We will discuss them as we proceed.

A similar definition is found in the newly published International Valuation Glossary – Business Valuation (“the Glossary”) where fair market value is:

Fair Market Value – a Standard of Value considered to represent the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, each acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or to sell and when both have reasonable knowledge of relevant facts. See also Market Value.

In the new Glossary, which is now published separate from the ASA Business Valuation Standards, when a defined term is used in a definition, it is bolded (as with Standard of Value above). When a definition is similar to another definition, it is referred to as “see also” and then named and bolded, as with Market Value above). When a definition has another name, the Glossary states, as below, “Also known as Basis of Value.”

We defined Standard of Value in an earlier post from the ASA Business Valuation Standards, but now we quote the Glossary regarding this term since it has been incorporated into the definition of fair market value.

Standard of Value — the definition of value used in a valuation (e.g., Fair Market Value, Market Value, Fair Value, or Investment Value). The Standard of Value affects the methods, inputs, and assumptions used by the business valuation professional. Also known as Basis of Value.

Four standards of value are noted in the definition. We will reference only fair market value at this time. The Glossary introduces another name for the definition, Basis of Value, which is the term used in some other jurisdictions.

Since Market Value, a concept used in other jurisdictions, is also referred to in the definition of fair market value, we show its definition from the Glossary:

Market Value – a Standard of Value considered to represent the estimated amount for which an asset or liability should exchange on the Valuation Date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing, and where the parties had each acted knowledgeably, prudently, and without compulsion. See also Fair Market Value.

The definition of Market Value brings another definition into focus, that of the Valuation Date, which is found in Revenue Ruling 59-60 but, unfortunately, not in the definition of fair market value.

Valuation Date – the specific point in time at which the conclusion of value applies. Also known as Effective Date, Measurement Date, or date of value. Contrast with Report Date.

We will refer to these definitions as we proceed. They are critical to an understanding of the definitions of fair market value and their implications for business appraisers and courts.

Fair Market Value Reflects Hypothetical Negotiations and Transactions

The definitions of fair market value above imply or suggest that fair market value is the result of hypothetical negotiations between hypothetical buyers and hypothetical sellers. In any negotiation, opposing sides look for facts or considerations that support their desire for a higher (or lower) price. Common sense, informed judgment, and reasonableness exercised on the parts of the parties can lead to agreement and fair market value.

Conceptually, fair market value (“FMV”) occurs at the intersection of hypothetical negotiations between the hypothetical willing sellers and buyers noted in the definitions above. The hypothetical parties have the characteristics of independence, knowledge, and lack of compulsion noted in the definitions.

The following figure provides a conceptual look at fair market value. The key elements from the definitions are highlighted around the figure. Hypothetical willing sellers have different interests than do hypothetical willing buyers.

In the world of fair market value:

  1. Hypothetical buyers are seeking to acquire expected business cash flows and negotiate price based on their associated risks and expected growth (from their viewpoints).
  2. Hypothetical sellers, who, if a transaction occurs, are giving up the expected business cash flows that the hypothetical buyers are acquiring, must consider the very same risk and growth factors (from their viewpoints). They negotiate price based on these factors.
  3. Hypothetical (or real) buyers desire to pay the lowest possible price, but that is not fair market value. Note that on the price continuum in the chart, i.e., with higher prices at the top of the chart and lower prices at the bottom, hypothetical buyers are reflected at lower relative price desires than hypothetical sellers.
  4. Hypothetical (or real) sellers desire to receive the highest possible price, but that is not fair market value, either. And note that hypothetical sellers are reflected at relatively higher desired prices than hypothetical buyers.
  5. Fair market value necessarily assumes that:
    • All hypothetical negotiations and marketing of the subject interest have occurred prior to the consummation of any hypothetical transaction, which occurs on the valuation date. The term “valuation date” is not found in RR 59-60. The closest we find is in Section 4.02 where we find this discussion of the analysis leading to fair market value:

      The history to be studied should include, but need not be limited to, the nature of the business, its products or services, its operation and investment assets, capital structure, plan facilities, sales records and management, all of which should be considered as of the date of the appraisal, with due regard for recent significant changes. (emphasis added)

    • Information should be considered historically and currently, or up to “as of the date of the appraisal.”
    • The hypothetical parties have agreed to and signed the documentation customarily needed for a transaction prior to or on the valuation date.
    • The definition of Market Value above makes the concepts of a hypothetical transaction occurring on the valuation date and “after proper marketing.” The definition of fair market value in RR 59-60 makes clear that a hypothetical transaction occurs because it is “the price at which the property would change hands,” which can only take place in a transaction.

These elements in #5 are important implications of the definitions of fair market value which are overlooked or misunderstood by some business appraisers, attorneys and judges. They are necessary, however, for the next element for consideration, the hypothetical transaction itself.

  1. Fair market value assumes that both hypothetical buyers and hypothetical sellers are both willing and able to transact, and that neither acts under any compulsion. The hypothetical parties negotiate at arm’s length and in their respective self-interests. And they engage in a hypothetical transaction with the following characteristics:
    • The transaction occurs for money or money’s worth, i.e., for a cash-equivalent price. This is clear from the definition of fair market value in the Glossary, which says the price is “expressed in terms of cash equivalents.” RR 59-60 advises similarly, though not in its definition of fair market value, but in Section 8, which addresses restrictive agreements:

      Where the stockholder is free to dispose of his shares during life and the option is to become effective only upon his death, the fair market value is not limited to the option price.  It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts, to determine whether the agreement represents a bonafide business arrangement or is a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth. (emphasis added)

    • If property cannot be transferred “for less than an adequate and full consideration in money or money’s worth,” the clear implication is that fair market value is a cash-equivalent concept as stated in the definition in the Glossary.
    • The transaction occurs on the valuation date. This fact is critical to understanding fair market value. We address this issue in more depth below.

The hypothetical transactions of fair market value could not occur on the valuation date unless all hypothetical negotiations, including the marketing of the subject interest, had not been concluded on or before that date. Similarly, the hypothetical transactions could not be concluded unless all customary documentation of the transactions had been completed.

  1. What brings hypothetical willing buyers and sellers to the intersection point of fair market value is their respective assessments and negotiations regarding the expected cash flows, risk, and growth associated with the subject interest.


The purpose of an appraisal is to simulate the hypothetical negotiations of hypothetical willing buyers and sellers and to determine, in the form of an opinion of fair market value, the intersection of their negotiations. We have the definitions of fair market value as well as some of the logical implications for the standard that flow from the definitions and related guidance in RR 59-60. So we can summarize this definitional discussion by concluding that fair market value:

  • Requires the presence of hypothetical willing buyers.
  • Also requires the presence of hypothetical willing sellers.
  • Reflects their hypothetical negotiations regarding the investment characteristics of the property under consideration and the fact that fair market value is almost always a going concern concept. So hypothetical buyers and sellers are looking at the same expected cash flows, growth and risks, whether of businesses as a whole or of interests in them, but from their respective positions.
  • Considers information known or reasonably knowable or available “as of the date of the appraisal.” or as of the valuation date.
  • Reflects consensus pricing at which hypothetical transactions occur.
  • Suggests that the hypothetical transaction occurs on the valuation date.
  • Requires that the pricing be cash-equivalent in nature, i.e., in money or money’s worth.

If any of these conditions are violated or ignored in any fair market value appraisal, the result will not be a reliable conclusion of fair market value. There is always, of course, room for the exercise of appraiser judgment, whether in the conduct and reporting of appraisals or in their formal review. And those judgments should be rendered in the context of applying common sense, informed judgment, and reasonableness in the appraisal or review process.

We will consider a number of the implications of this discussion of fair market value for appraisal and appraisal review in future posts. This broader interpretation of fair market value places important responsibilities on appraisers and on courts as they seek to apply the definition in specific valuation situations. Appraisal review requires a full understanding of the standard of value under which any valuation report is to be evaluated, whether in a formal (or informal) review by a qualified business appraiser or in a formal review in a judicial context.

[1]      American Society of Appraisers, ASA Business Valuation Standards, (Revision published November 2009), “Definitions,” p. 27.

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