Fair market value reflects market reality

A story that recently appeared in the newspaper told of Jane Doe who had purchased a home from a developer in 2004 for $800,000 with the intention of flipping it later for a profit. In 2006 she offered the property for $1 million dollars and there were no takers.

With a slowdown in the market, the same developer, in an effort to unload unsold inventory, was offering the same home at $700,000. Ms. Doe was upset because the developer was preventing her from obtaining "fair market value" for her property. Apparently there is a misunderstanding among some people as to what constitutes fair-market value.

Fair-market value is not a number pulled out of the air. It is a reflection of what is happening in the marketplace, good or bad. Unfortunately there are people who feel that they are entitled to receive a profit on their investments, regardless of how much they paid or when they invested. We are witnessing today significant changes in real estate values throughout the country. Security investors understand that markets change and that an investment that is low today can be high tomorrow and low again the day after.

The commonly accepted definition of fair-market value is "That certain price in terms of cash or equivalent that a hypothetical buyer would pay, that a hypothetical seller would accept, for a property or business, all parties being in possession of the pertinent facts, none of the parties being compelled to act, and the property or business having been exposed to the market for a reasonable period of time." The key element is "willing buyer and willing seller." It then begs the question, "How does one know what hypothetical buyers are paying and what hypothetical sellers are accepting?"

In the case of real estate it is not too difficult to develop information from the marketplace or from public records. Most residential property is sold through Multiple Listing Services whose members have access to sales data. Declarations of Value and Transfer Taxes paid ($2.05 per $500), a matter of public record, also reveal the reported sales price of real property.

When a business is sold, however, there is little local transaction data available. Businesses are not normally sold though Multiple Listing Services and few, if any, documents are ever recorded. In fact, even if a selling price is known, it has little meaning without other relevant information such as financial reports, the components of the sale (accounts receivable/payable, value of inventory, value of fixed assets, etc.), or whether it was an asset sale (tangible and intangible) or stock sale (transfer of corporation shares).

There are sources however, that report on the sale of closely held private businesses. The information is contained in private proprietary data banks. All businesses and professions (manufacturing, construction, wholesale, retail, service, health, etc.) have been assigned an SIC (Standard Industrial Classification) or NAICS (North American Industry Classification System) number by the U. S. Office of Management and Budget. Transaction data is gathered by these data banks from business brokers, accountants, banks, etc. and maintained under the appropriate SIC or NAICS code. The data is based on nationwide transactions of closely held, private companies.

Financial information is readily available on public companies from the companies and security brokerages. The prices at which their securities are traded are available as near as your local newspaper. Closely held private companies, however, are totally different from public companies and their selling prices, when available, cannot be compared. Among the differences are:

Differences in risk and return

Smaller companies are riskier than larger companies, therefore the return on and of investments in private, closely held companies must be higher.

Differences in liquidity

There's a ready market for shares in public companies and they can easily be turned into cash. There is no such market for interests in closely held, private markets.

Differences in the behavior of the players in each market

Typical players in the public market have little, if any, attachment to the companies in which they hold shares, and their investments are typically diversified. The typical player in the private market usually owns and operates one business, is usually emotionally attached to the business, and is often times the founder of the business.

Differences in operations and management

Public companies are generally highly departmentalized and have many levels of management, the latest in equipment, and a high level of talent. There is often very little involvement between one department and another. Private, closely held companies are usually managed by the owner who wears all hats and "lives and sleeps" with the business.

Differences in borrowing ability

There is no comparison between the borrowing ability of public companies and private, closely held businesses. Public companies can issue stock, and have great borrowing capacity with lending institutions. Closely held companies must rely on the personal assets of the owner or on the tangible assets of the business.

Differences in the anticipated holding periods for investors

Investors in public companies are in and out of their investments. They buy when it's low, sell when it's high. They love the profit, hate the loss and are seldom in love with the shares. In many cases they may only own the shares for months, weeks, days or even hours. Owners of interests in closely held, private companies are usually married to the business and do not have the luxury of being in and out. In many cases it may take a year or longer to dispose of their interests, if at all.

Differences in decisionmaking

Decisions in public companies are usually made by highly skilled, highly educated and highly paid professionals. Major decisions often require ratification by a board of directors. In privately owned, closely held businesses the decisions, right or wrong, are usually made by the owner.

Differences in financial information

Public companies generally employ highly paid accounting firms that are required to produce periodic audited financial reports that are readily available to the public. Financial reports on private, closely held companies are rarely audited and are highly confidential.