Join Jim Stice for an in-depth discussion in this video Basic appraisal concepts, part of Finance Foundations: Business Valuation.
- There are certain key concepts in the fields of appraisal and business valuation that have been used for years. These concepts are as follows. Perform the valuation in the context of a generic owner who will sell the asset in a hypothetical transaction. Assume that this hypothetical transaction will occur in the principal or most advantageous market for the asset. Assume that the market participants, both the generic seller and the hypothetical buyers, are informed and knowledgeable about this particular asset.
Assume that the hypothetical buyer will put the asset to the highest and best most valuable use. Now, in this discussion, I will use the phrase fair value, which I define as follows. Fair value is the price that would be received to sell an asset in an orderly transaction between knowledgeable market participants. Now, note I have adapted this definition from the definition created by the FASB, the Financial Accounting Standards Board, the private group that establishes accounting principles in the United States.
Now, the hypothetical transaction. This hypothetical transaction is assumed to be an orderly one, meaning that it is not a forced or hasty sale. In addition, this hypothetical transaction is assumed to occur between two unrelated, informed market participants. Thus, the fair value of an asset is not the price at which the current owner, with her or his special skills or unique handicaps, could receive in selling the asset. Instead, the fair value is the price that would be acceptable to a generic seller and a generic buyer without any particularly special skills or unique handicaps.
The principal or most advantageous market, recall that the hypothetical transaction is an orderly market transaction. Well, a natural question is, "Which market?" For some assets, there is a principal market in which that asset is typically traded. This principal market would be associated with the largest trading volume for the asset in question. For example, if the asset in question is a share of Microsoft stock, then the principal market is the NASDAQ market, and the relevant price in determining the fair value of the share of stock is the price at which a shareholder could sell the share in the NASDAQ market.
Similarly, the principal market for trading pork belly futures is the Chicago Mercantile Exchange. Don't ask me how I know that. Now, if there is no one principal market in which a company could sell the asset, then the fair value should be determined using the price that could be obtained in the most advantageous market of those available. Now, the market participants. As mentioned earlier, the price of the hypothetical transaction used to determine the fair value of an asset is the price that would occur between two unrelated, informed market participants.
Specifically, the hypothetical market participants are knowledgeable about the asset in question, have the financial resources to buy and sell the asset, and are interested in buying or selling the asset. For example, neither you nor I have much knowledge of pork belly futures, so any price that we might agree to would not be appropriate to use in determining the fair value of a pork belly future. Because we are not knowledgeable, we probably don't have the necessary financial resources, and we are also probably not interested in buying or selling pork belly futures.
The highest and best use. A key assumption in appraising an asset is that in an unconstrained market with ample time given for market participants to consider whether they want to buy an asset, the asset will be sold to the market participant who will use that asset in the most valuable way and who will pay the highest price for the asset. In shorthand terms, it is assumed that the asset in question will be put to its highest and best use. Now, for most financial assets, such as a share of stock, the highest and best use is on a stand-alone basis.
For example, a share of Microsoft stock is not worth more or less if you also own a piece of undeveloped real estate and a license to operate a steel mill. Those are unrelated. In this case, it is said that the highest and best use of the share of Microsoft stock is in exchange, meaning that the way to get the most value out of the share of stock is to exchange it or sell it. In contrast, for many non-financial assets, such as a steel furnace used in producing raw steel, the highest and best use is in use, meaning that the asset is most valuable when used in concert with other related assets.
Accordingly, a steel furnace is probably not of much worth to you or to me, but it would be of great worth to a company that also owns a piece of undeveloped real estate and a license to operate a steel mill. When the highest and best use of an asset is in use, in determining the fair value of the asset, it is assumed that the hypothetical market participant who would purchase the asset also owns the related assets that would allow it to maximize the in use value of the purchased asset. Valuation techniques.
So those are some general appraisal or valuation concepts. In the field of asset appraisal, there are three primary asset valuation techniques, the market approach, the income approach, and the cost approach. We will discuss these three approaches in the following sections.
Make sure to check out the Stice brothers' other accounting and finance courses to understand the other economic factors that impact your business.
- Using market, cost, and income approaches to business valuation
- Valuing homes
- Valuing companies by multiples
- Using price-to-sales ratios to value companies
- Using discounted cash-flow analysis to estimate value
- Valuing McDonald's as a case study