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Business Valuation Article - Types and Definition of Value

Definition of Value

The Merriam Webster Dictionary gives the definition of value (among other things) as:

  • the monetary worth of something or market price

  • a fair return or equivalent in goods, services, or money for something exchanged

  • relative worth, utility, or importance

We can see some of the guiding principles and methods of business valuation in some of the above definitions.  The value of something arises from its comparison with other things of known value, or through its relative worth.  But these definitions can be vague and non-specific when it comes to most business valuations.

The generic definition of value of a financial asset is the net present value of future cash flows. 

However in business valuation there are different circumstances where a different standard of value is required. 

These standards could include:

  • Book value

  • Replacement value

  • Liquidated value

  • Market value

When it comes to business valuation, the type or standard of value becomes critical in selecting the appropriate business valuation methods.  This article hopes to clarify the two most common standards of value and how they are used in different circumstances.

 

The International Valuation Standards (IVS) defines “value” as:

  • An economic concept referring to the monetary relationship between goods and services available for purchase and those who buy and sell them

 

This implies that market value is distinct from “price” and “cost” – where price is defined as the amount asked, or offered, for goods or services and cost is the price that is paid for goods or a service.

 

There are subtle differences that can lead to different conclusions – I may desire any pen and be prepared to pay $2.00, however it may have cost you $1.30 to manufacture.  Depending on the situation, price and cost may not necessarily reflect value.

 

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The Standard of Value

Within Australia there are three typical standards of value applied in business valuations:

  • Market Value – what will anyone be prepared to pay for the business?

  • Strategic value – what will a specific buyer be prepared to pay for the business?

  • Liquidated value – what will anyone be prepared to pay for a business under “stressed” or non-going concern conditions?

In most cases the standard of value in question is that of market value. 

The ATO provides a number of different interpretations of market value, based on the context.  For instance there is an “ordinary meaning” to market value and there is a more judicial meaning. 

Market value was defined by the High Court of Australia (Spencer v. The Commonwealth of Australia (1907) 5 CLR 418) as:

 

  • the price that would be negotiated in an open and unrestricted market between a hypothetical, knowledgeable, willing, but not anxious purchaser, and a hypothetical, knowledgeable, willing, but not anxious vendor, acting at arm’s length.

 

This implies that market value requires adjustments for things such as:

  • Wages above or below industry levels.

  • Rents charged above or below market levels.

  • Non-arm’s length transactions such as director loans, or loans between related entities.

  • Pricing agreements from suppliers that are specific to the owners and are not available to the wider market.

 

In some situations, especially in the levy of land tax, rights of shares issued to employees or in relation to superannuation, there is a statutory definition of market value.  If a statutory definition exists then it must be used.

 

In some circumstances the concept of “fair value” can be different to “market value”.  Fair value is primarily an accounting concept specifically used for financial reporting purposes.

 

Whilst it is generally defined in a similar way to market value, the Australian Accounting Standards Board (AASB) define it as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  So if there exists a similar price for a similar asset, then the price at which exchange is agreed is considered fair.

 

In an Australian context, market value may need to be adjusted for a more standardized or normalised arms length transaction, and hence market value may be different to fair value.

 

One final concept that is related to market value, especially when considered by the ATO is the assumption that market value is based on an asset’s “highest and best use”.

 

The concept of “highest and best use” refers to any potential for an asset to have a use that is higher than the current use.  For example:

 

  • When we buy a car we are assuming (often through regulatory means such as roadworthy certificate) that it can be registered and driven on the road and that it complies with roadworthy standards.

  • We assume that a house purchased can be lived in and will meet expected

  • We purchase a business on the assumption it is a going concern.

 

In the business context a good example is when a motel has been purchased and it has been advertised as having all necessary local planning approvals.  Should this not be the case then perhaps the property should be more appropriately valued based on vacant possession, rather than a going concern.

 

In general, all inter-related assets should be valued on the basis of the same use.

 

Strategic value relates to the value that can be ascribed to a particular party with very specific circumstances.  It recognises the additional benefits that a specific buyer will receive from the business.

  •  “…the benefits that a person or an entity enjoys from ownership of an asset. The value is specific to that person or entity, and may have no relevance to market participants in general. Investment value and special value as defined in these standards fall into this category”.

 

In some cases a business will sell for a price greater than market value.  This premium represents the additional value that the buyer perceives will arise as a result of them acquiring the business over any other party.

 

Liquidation value represents the value that can be realised from an orderly disposal of all assets and liabilities.  It is primarily the value associated with a business that has closed or is not a going concern.

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Examples of Market Value and Strategic Value
 

  • The current share prices listed on the stock market are typically considered a measure of the market value of the relevant company.  It is the price that anyone can buy and sell a particular stock.

  • If Coles is currently listed on the stock exchange for $18 per share and Woolworths gains approval to pay $35/share then this is considered strategic value.  The price paid is in excess of market value, but it is worth that much to Woolworths to gain 80% of

  • In 2012 Virgin Australia purchased a 60% stake in Tiger Airlines for $35m.  The remaining 40% stake was purchased 12 months later for $1.  The value to Virgin of the additional shareholding was no more than the 60% stake it initially purchased.  This is the strategic value of the remaining shareholding.

  • The market value of an existing waste treatment business that has significant environmental liabilities associated with land contamination and non-compliant discharge.  However the business may have strategic value to another company that can leverage the technology and the site to gain a significant market share.  In this case the market value of the existing business may be nil – but the value to one particular buyer may be $1m or more.

  • In 2018 the private dairy company St David Dairy was purchased at an 11x EBITDA multiple ($15.25m transaction).  This was considered a strategic transaction as the buyer believed it could achieve economies of scale and leverage through its existing business and was worth paying the additional price above market value.

 

The Holy Grail for most business owners is to achieve a sale of their business to a strategic buyer and therefore receive a significant premium to market value.  This requires a significant amount of preparation and positioning in order to attract such an offer.  Rarely will a business under financial distress attract a premium to market value. 

 

However with the right knowledge and expertise, the treasure chest of strategic value can be found and opened.

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