There’s an adage of uncertain derivation that a picture is worth a thousand words. I used that adage, that quote, at the Pennsylvania Institute of Certified Public Accountants. They had a valuation and forensics conference in King of Prussia, Pennsylvania. I was over there and I spoke about presenting complex financial concepts to judges and juries and also about buy-sell agreements. One of the things that I talked about was the idea that a picture is worth a thousand words.
I can’t tell you how many times I have used something like this a PowerPoint with a lot of words on it to talk about fair market value. Well, that may not be a thousand words there, but there’s quite a few and a lot of dense text. It’s hard to read along. So what if I substitute a little picture like this to talk about fair market value.
I have a little diagram on board. So let’s talk about what is fair market value. I could quote Revenue Ruling 59-60 or I could quote the International Glossary and it would just be words. But let’s do it with a picture. Fair market value is a hypothetical concept involving hypothetical willing sellers and hypothetical willing buyers. These hypothetical parties negotiate over a subject interest, a company or an interest in a company, or something like that. What do they negotiate over? The expected cash flows, the growth of those cash flows, and the risks associated with achieving those cash flows -for the company or the interest.
So there’s a framework within which the negotiations occur. Now obviously, any hypothetical or real seller wants the highest possible price. Any hypothetical or real buyer wants the lowest possible price. Those concepts are fine, but in the world of fair market value, fair market value occurs at the intersection of where these parties can negotiate and can agree. So what is fair market value? It’s a hypothetical concept. It involves hypothetical parties that are willing and able to trade. They are under no compulsion. There are no motivated sellers or motivated buyers in the world of fair market value. They have the financial capacity to engage in a transaction, and they are fully, or at least reasonably, informed about the subject. They engage in a hypothetical transaction on a valuation date for cash, that is, for money or money’s worth, a cash-equivalent price. So that, in a way, is fair market value. It is these hypothetical negotiations. But the intersection, you see, is relatively small where the willing buyers and the willing sellers get together.
Now when we do an appraisal, what we’re trying to do is mirror the hypothetical negotiations of willing buyers and willing sellers. It’s important in every appraisal that both the hypothetical sellers and the hypothetical buyers show up. I’ve seen a number of appraisals over the years where one or the other party didn’t show up in the appraisal process and you get a distorted or biased conclusion if that’s the result.
So a picture is worth maybe a thousand words. I will say this – since about 2017 when I first tried this slide, I’ve been much more successful and much more entertaining when talking about fair market value when I’ve been in court or when I’ve been talking about fair market value along the way.
This is Chris Mercer. I’m in Memphis, Tennessee today, with one more Valuation Video. I look forward to coming to you with future videos. Feel free to call me or to email me if you want to talk about fair market value or any valuation issue. If you please, go to ChrisMercer.net and you’ll be able to find this video there or on LinkedIn as well. Good day.