What is fair market value (FMV)?

The fair market value of a property or business is the standard used by the Internal Revenue Service (IRS) for tax purposes. Insurance companies also use it to calculate the replacement cost of merchandise, office equipment, real estate, etc. FMV is generally accepted as what something is worth, not what someone is willing to pay for it. 

Fair market value differs from valuation, though the two numbers can match if you have a third-party 409A valuation. In most cases, the buyer and seller must know the asset's value and behave in their best interests. They also cannot be under any undue pressure to sell (or buy) within a shortened timeframe. That tends to alter the price for at least one of the parties. 

Other terms often confused with fair market value are “market value” and “assessed value.” Those concepts have their place in certain transactions, but they’re calculated using other variables, like consumer demand and inflation. Either could affect a business's sale price, but that doesn’t mean the business's “value” changes. 

Assessing fair market value

A company's fair market value must be assessed before a contract for equity financing can be drawn up. Public companies can use financial statements and the selling price of their stock on an open exchange, while private companies need to rely on comparative markets and professional appraisals. Profit and loss statements are also a factor in the equation.

Assessments usually start with the balance sheet. Subtracting the company’s liabilities from its assets can provide a book value, but that doesn’t account for current revenue or future cash flows. In some cases, the company could also own equity in other businesses. These varying characteristics make it difficult to have one specific formula to assess fair market value. 

The concept of fair market value keeps emotions out of business financing and acquisitions. Owners usually “feel” their company is worth a certain amount. FMV provides a “true” net worth that can be used to set the stock price, determine tax liabilities, and mitigate risk for investors and lenders. 

Who decides fair market value?

Ultimately, economic conditions determine a business's fair market value. You can hire a business assessor to do the math, but they’ll use hard data from your financial statements and public sales records from similar businesses. What your competitor sells their business for could become your fair market value if the two businesses are alike.

Professional appraisers can estimate a business's fair market value, but market activity and costs can alter that assessment at any time. For public companies, a shift in market demand can increase or decrease the stock price. The fair market value of your property and equipment can go up or down due to inflation or depreciation.

Example: Your valuation says your company is worth $1 million. That’s what’s left on the asset side of the ledger after subtracting your liabilities. One of those assets is a building appraised at $500,000, but the FMV is 10% lower than that because that’s what other similar buildings sell for. Your market value is $1 million. Your fair market value is $950,000.   

What is FMV for a company's stocks?

Several values are involved when describing your company’s stock. The current market value is what new shareholders buy it for. The cost basis is what they pay the day the shares change hands. The fair market value is what it’s worth. That’s an important distinction for investors. Paying too much over fair market value increases the risk of loss. 

Private companies issuing shares of stock to investors must use relevant facts when structuring the deal. Since there’s no market movement to increase or decrease share values, fair market value sets the stock price. That number is used for the face value of common or preferred stock offered in equity financing. Serious investors will verify the accuracy of that number. 

Business appraisers and financial analysts use comparative market analysis to determine a company’s worth. Cash flows and expenses also come into play because a willing buyer will want to know the company’s bottom line. They’ll also want to see a balance sheet and a statement of shareholder equity. These are all tools to assess fair market value.        

Fair market value vs. market value

What you pay for it is not necessarily what it's worth. That’s true in real estate transactions and when buying stock. The fair market value of a property should be used as a reference before making any major purchase. Market value is what the market is willing to pay. Savvy investors look to pay under market value because it increases the potential return.  

Depreciation is another variable to pay attention to. Equipment values decline as time passes. Paying for something based on an overinflated market value could negatively impact your balance sheet when you use fair market value and depreciation to calculate the value of that asset. You might be better off waiting for the current market to cool. 

Don’t forget about taxes. You pay sales tax based on the selling price of the equipment. Paying market prices higher than fair market value means paying more taxes than you should. Some states charge sales tax on home and commercial real estate purchases. Property taxes are paid based on the fair market value of the property.  

Please consult with a tax professional for additional guidance on your situation.

Tax treatment of stock options

Stock options are equity compensation that allow the holder to buy stock at a specific price. That price is often the fair market value of the stock when the options are issued or awarded. There’s no tax liability to hold an option, but there is one if you exercise it. The IRS charges 10% to 37% regular income tax if you sell your shares.       

Fair market value is also part of the equation when options traders exercise their options. The difference between an option's strike price and fair market value is known as the “spread.” That’s what you pay taxes on. For example, if you pay $1 for each option and the strike price is $3, you’ll be taxed on the $2 difference if you exercise the option.

The tax rate for options traders could be the standard income tax rate, an alternative minimum tax (AMT), or a capital gains tax. This is another subject you should discuss with your accountant. Options trading is more complicated and risky than simply buying and selling stock. Make sure you know what you’re getting into before you try it.  

Please consult with a tax professional for additional guidance on your situation.

How to calculate FMV 

Several factors affect fair market value. The first is the price that you pay for a property or equipment. Then there’s the appraised price that a professional appraiser sets. Finally, there’s the price being paid for similar properties or equipment on the open market. There’s no absolute formula for calculating FMV, so all three variables are typically used. 

Discounted cash flow analysis (DCF)

Investors looking to buy a business might use the discounted cash flow analysis to determine its fair market value. This formula factors in the projected cash flow from several future years to determine a company's worth. This method estimates the time value of money, so the discounted rate could be the interest rate or weighted average cost of capital. 

Asset approach

Another way to determine fair market value is to add the company’s assets and subtract liabilities. Unfortunately, this method doesn’t factor in revenue or future cash flows, so it does not accurately represent true worth. However, it can be an effective calculation if you plan on liquidating the business after buying it.   

Market/comparative approach

The most common way to determine fair market value is to compare what similar businesses, properties, or equipment sell for on the open market. This is called the comparative market approach. Insurance companies set rates using this method. Real estate appraisers use it to calculate property values. Investors rely on it to assess potential deals. 

FAQs about fair market value

How is FMV calculated?

Fair market value (FMV) is calculated using a combination of appraised, market, and comparative values. Since there is no absolute formula for FMV, averages of these three variables are used. 

Is FMV the same as the selling price?

The fair market value can be the same as the selling price if the buyer and seller are willing participants in the sale and neither is pressured to raise or lower the price. 

What is the FMV of a business?

The fair market value of a business can be determined by subtracting total assets from total liabilities and then factoring in future cash flows at a discounted rate. 

Wrap up

Businesses use fair market value to set a valuation to sell or attract investors. FMV is also known as the “true” value. While it’s an important number in financial transactions, there’s no absolute formula to calculate it, so you’ll need to compare the appraisal, market, and comparative values of similar purchases to learn what something is truly worth.   

Kevin Flynn is a guest contributor. The views expressed are hers and do not necessarily reflect the views of Rho.

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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.