Why fair value isn’t always the right value

By Bakley Smith, CFA

The debate between fair value and historical
cost accounting is a hot topic for academics, regulators and investors. As
noted by a University
of Chicago Booth School research paper and Harvard
Business Review, the debate centers on the use of fair value accounting and its
impact on the economic crash of 2008, as well as its appropriateness in
accounting for companies going forward. Aswath Damodaran, a professor of
finance at NYU’s Stern School of Business and a leader on the topic of business
valuation, highlights many of the issues
surrounding fair value and its use in business valuation. 

Fair value can be calculated in many ways and is often
considered more of an art than a science. It is meant to be an estimate of the
market price for an asset, but fair value depends largely on the circumstances
surrounding the valuation. For example, is the company intending to be sold or
held? Is the company being valued by the seller or the buyer? Is the valuation
professional employing relative or intrinsic valuation, or both?

To cut through some of the noise surrounding
this debate, it’s important to try to boil it down for those most likely to
feel the impact – the small and medium size business owner, the investor and the
business
valuation professional.

Influence of capital markets

Businesses not actively involved in capital
markets may be cautious in their approach to fair value accounting. After all,
the fair value approach relies on widely disseminated market information which
most small and medium businesses do not have. For a small business that lacks a
clear public company comparison or other market data to determine a value, the
notion of fair value can be deceiving. As Professor
Damodaran suggests, “Replacing existing
book values of assets (which measure capital invested) with the fair or market
value of those assets replaces a useful piece of information with one that is
redundant (if it just reflects market value), misleading (if it incorrectly
tries to reflect market value) or confusing (if no one is quite sure).”

The debate

The debate about historical and fair value
accounting is an old one and is reflective of a mindset difference between pure
accounting and capital markets participants. Historical accounting makes use of
the price paid for assets and liabilities and puts those values on the
company’s books. For example, when a manufacturer buys a robot for production,
the paid cost of the robot will be added to the company’s assets and will then
be depreciated over a period time that is determined by the company in
accordance for general accounting principles. If there are liabilities
associated with the purchase, those will go on the balance sheet at the time of
the transaction.

Investment banks and asset managers also make
use of fair value where the value of assets and liabilities are “marked” at the
end of every day. The balance sheet changes on a daily basis in accordance with
market prices. This has the benefit of being timelier. The most recent price of
an asset is highly relevant to investors and executives at financial firms. But
it also has the drawback of being less reliable. In aggregate, fair market
valuation techniques can have the effect of accelerating market effects as
prices rise or fall.

Takeaways for valuation professionals

The valuation professional that supports small
and medium size businesses has to find the best way to make reliable market
comparisons and to achieve a company value that can be defended.  Careful documentation of the financial data
and strategic thinking gathered during the valuation process will allow the
valuation expert to present a defensible
value.

Market comparisons
should be made carefully, and with relevant data to support, such as Pratt’s
Stats database which includes company transactions or the Sageworks
database of private company financials.

Using a market-based fair value exclusively is
inherently more aggressive and can lead to issues for businesses and potential
investors or acquirers because of the exacerbated valuations that come from
fair value. Leveraging the income,
asset and market approaches help to provide a
balanced, reasonable assessment of value.

Adjustments can be made, such as the discount
for lack of marketability, to help determine an accurate value. A fair value
adjusted valuation can be illuminating and can provide a clearer picture of the
company value. Private company valuation, commonly called “an art, not a science,”
is a service that relies on expertise. Developing a reliable process, gaining
access to company databases, and leveraging
technology to simplify each step are all reliable
strategies for creating building a strong business valuation practice. 

About the Author Bakley Smith, CFA is the founder of Lead Agency, a service that connects top businesses with strategic, marketing and financial resources. He resides in New York City with his wife. Read his Blog

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