What is the fair value of an asset? Sounds like a simple question but the question has taken on a life of its own, given recent changes in both accounting and legal standards. In both contexts, the rule makers contend that their objective is to ensure that assets are recorded at fair value and have created rules to ensure that this happens.
Let us start with accounting. The push towards fair value accounting has now become an article of faith for accounting standards boards. In the United States, FAS 157 (the very fact that we are at rule number 157 tells you something about how accountants think - the more rules the better) provides a synopsis of what the accounting definition of fair value. I have expressed my skepticism about fair value accounting before on this blog and made my case for why this is not only a good idea.
In legal circles, the hypocrisy about fair value is even greater. Appraisers are supposedly unbiased and fair in their estimates in value, no matter who they work for or which side of the legal divide pays them. The Internal Revenue Service has made this requirement explicit in its guidelines for appraisers. All of the valuation appraiser organizations - The National Association of Certified Valuation Analysts (NACVA), American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA), Institute of Business Appraisers (IBA)- argue that their members provide fair, unbiased estimates of the values of businesses.
I have a simple definition (and test) of fair value. If an asset is valued at fair value, the appraiser (or his client) should be indifferent to being either a buyer or a seller at that value. If you are an appraiser valuing your business for tax purposes, would you really be willing to sell your business at the appraised value? If the answer is yes, you have stayed true the notion of fair value. If the answer is no, the talk about fair value is just talk... If you are the tax authority valuing the same business (for tax purposes), would you be willing to buy the business at the appraised value? If the answer is no, you too are guilty of hypocrisy.
Let's be honest. Asking "biased" appraisers to estimate fair value is a hopeless task; the bias comes from the way appraisers get compensated/ paid. Either change the way that we hire/pay appraisers or accept that each side's appraisers are going to come up with valuations that reflect which side of the divide they are coming from.
Good post!
ReplyDeleteFurthermore, I have the impression, that appraisers (can only speak for Austria/Germany) often stick to rules made by certain institutions like German IDW (= Institute of Public Auditors in Germany); e.g. IDW announces equity risk premiums, methods to estimate risk free rate, in general, the methodology how to calculate discount rates etc.
Auditors often stick to that rules due to legal reasons. It is easier for them to defend their valuation in court, when they can rely on such publications. If these "rules" are always appropriate is the big question.
In my opinion there is no such thing like a fair value, because valuation is always subjective and there is, if at all, a "fair value range". Just look at the various cash flow forecasts of equity analysts and even at the changes one equity analysts makes over time for the same company.
All in all, I think fair value accounting, if not based on "true" market values (like for stocks of a listed company), is always prone to manipulation/window dressing.
Nice insights...
ReplyDeleteAny thoughts on rating agencies' conflict of interest...
Hi Prof, that’s a nice topic to blog about. But I don’t think I agree with your idea of Fair Value. I think it amounts to substituting one idealistic notion with another. Just as you will never find a truly ‘unbiased’ appraiser, since no one is going to appraise a project or an asset simply as a hobby with no stakes or payouts involved, I don’t think you will ever find anyone who will be neutral to a price of an asset as both, a buyer and a seller. If they were, why would they buy the asset over selling it or the other way round?
ReplyDeleteWhenever you consider the buyer’s side of things, essentially, he is buying that asset because he thinks the price he is paying for it is less than what the benefit he will be deriving out of it will be worth. Similarly, a seller sells an asset primarily because he feels the price he is getting is more than what the benefit he could have derived by keeping the asset would be worth. Hence, their objectives towards the trade itself are different and indeed complimentary. So saying that the fair price of an asset is the price at which you wouldn’t mind buying or selling it, basically means you have no use of the asset as either a buyer or a seller. And that will never be true. Because, as a seller, you will always have some interest in any asset- the compensation you derive out of selling it.
If I were to describe ‘fair’ value of an asset, I would say something like: Fair value is that value at which all the benefits to be derived from the asset are clearly and explicitly mentioned (including gains to be made from the asset’s purchase) and all these benefits are quantitatively reflected in the value of the asset. Although this would imply that the fair value is only the ‘buyer’ side fair value, it will in fact help us arrive at the ‘real’ fair value.
If, as a buyer, I honesty disclose and build all the benefits I am going to receive from an asset, into the asset value, I will in turn be putting the onus on the seller to price the asset accordingly. The seller will thus raise or lower the price of the asset based on the benefits its intended buyer will be receiving. The price at which a sufficiently large no. of buyers will be willing to buy the asset and a sufficient no. of sellers will be willing to sell the same asset will then be the fair value. This is something like bookbuilding, but then the only real way of ‘fair’ price discovery is through the market mechanism. Any appraisal done at an isolated or individual level is bound to have some dubiousness with regards to its ‘fairness’. I guess that’s why most regulators mandate valuation through multiple agencies- an attempt (albeit feeble and token) to simulate a market with a larger no. of valuers.
As such, I would define fair value as: The price at which value of the real benefits derived by both, the seller and the buyer, remain largely constant if the trade was to happen at that value at different points of time over a reasonably large time period.
Do let me know your thoughts on this.
Professor,
ReplyDeleteI have one issue concerning your definition/test of fair value. Let us consider the appraiser whose characteristics are as follows:
Situation A. Personal risk aversion is above market, so the appraiser requires higher rate of return for the same amount of risk.
Situation B. Appraiser’s portfolio is not diversified, therefore she is subject to nonsystematic risk and also requires higher rate of return for the same amount of systematic risk.
If the appraiser is aware of the above, she would perceive market required rate of return as lower than his own.
Therefore the value of the enterprise (as the present value of expected future cash flows) calculated using market required rate of return (ie. estimated using CAPM model) would be higher than value acceptable for appraiser herself. It implies that appraiser would estimate market fair value, but because of her personal characteristics or characteristics of her portfolio, she wouldn’t be “willing to buy the business” at the appraised value.
Another issue is the situation, when the appraiser might be “willing to buy”, but not “able to buy”, for example because of insufficient funds.
Obviously, I agree with you, as far as compensation bias is concerned. Whether it is direct (payment for appraisal) or indirect (possible benefits from future transactions with client).
I would appreciate your opinion.
I don't see anything idealistic about my position that a fair value should be one that you should be indifferent between buying and selling. I am not an adviser to the tax authorities, but if I were, I would make a simple suggestion. In one out of every ten tax appraisals of business value, reserve the right to buy the company at the appraised value. You will be surprised at how quickly appraised values become more realistic.
ReplyDeleteDear Sir
ReplyDeleteI read your book on valuation 2 years ago and together with what I picked from Warren Buffet's annual Letter to shareholders, I can now say I am beginning to make good investment decisions (measured by 5% excess returns over benchmark index for two years)
Coming to my question
In you valuation of Tata Steel, you have taken the book value of non operating assets and that makes a substantial difference to the final share price. I think that the non operating asset should be valued at the cash it generates for Tata Steel and its term value should be added to firm value of Tata Steel.
Afterall that is what Tata Steel would have looked at while making the investment.
Please let me know your ideas.
This article is definitely worth saving to the favorites. I read just about everything on this subject and most of it. This material is quite a bit different in that the information is up to date and written by an author that is on the cutting edge of the subject.
ReplyDeleteFair Value
Accounting