What is Fair Market Value and How Do You Calculate It?
A significant part of running a business is knowing the dollar amount your company owns in assets — not to mention the total dollar value of the business itself.
You must know the fair market value of your firm’s assets to maintain clean and accurate books, buying and selling assets, raising capital, and more.
Below, we’ll explore fair market value, why it’s important, and how to calculate it.
What is Fair Market Value?
Fair market value (FMV) is essentially the price an asset would sell for in an open and competitive market. FMV assumes both buyers and sellers have sufficient information and time to complete a deal that best serves each party’s interest.
Note: market value and fair market value are slightly different. Market value is simply the price of an asset on the market, whereas FMV considers the “open and competitive market” factors just described.
Fair Market Value vs. Present Value vs. Book Value
Your business has a few values attached to it aside from the FMV.
The first is present value (PV).
PV is the value of cash flows occurring now as well as those that will potentially exist in the future, given a defined rate of return. If future cash flows are determined to be higher based on analysis, your firm’s present value increases.
Then, there’s book value. Book value represents the value of an asset based on its balance sheet balance. For example, if you depreciate a company vehicle over time, its account balance will decrease on your balance sheet. That represents a decrease in the vehicle’s book value.
Why is Fair Market Value Important?
FMV plays a variety of roles in your business.
Purchasing, Selling, or Disposing of Assets
Fair market value is vital to fair transactions within the marketplace. You want to know the fair market value of an asset before buying it to ensure you’re not being ripped off.
Likewise, if you’re selling an asset, buyers want to know its fair market value for the same reason.
Of course, you also need to know the fair market value to record the asset correctly in your books. This is also true when disposing of assets — aka “throwing them out.”
Business valuations are vital for establishing sensible goals and the strategies for reaching them.
You also need valuations in certain instances:
- Buying or selling a business
- Raising capital from investors
- Issuing stock options
One of the business valuation approaches — the market approach — requires you to know the FMV of the business in question.
If you’re insuring your assets, insurance companies will often want to know the FMV of those assets.
FMV is generally used to establish a bought or sold item’s value for tax purposes. For example, if you sold an asset, the IRS would use the initial FMV (when you bought the asset) and the final FMV to determine tax consequences.
Part of that calculation is depreciation, which, as you’ll see next, can factor in FMV calculation.
How to Calculate Fair Market Value: The Four Methods
There isn’t an exact formula to calculate FMV like with other crucial accounting and finance numbers. Instead, you can use a few different methods for arriving at an asset’s approximate FMV.
Cost Minus Economic Depreciation
This method simply subtracts an asset’s economic depreciation from its original cost to arrive at the new FMV. In general, you can only use this method if you acquired the asset at FMV.
Now, economic depreciation is not the same as the accountant and IRS versions of depreciation. Instead of being a theoretical formula, it’s rooted more in real-world factors like wear and tear. Economic depreciation happens rapidly at first, then slows down for the rest of the asset’s life.
A great example is a new car. The vehicle’s value drops like a rock when it rolls off the lot, but the depreciation slows down quite a bit after.
The Comparable Sales method is pretty common, and it's handy for real estate transactions (given the large transaction size).
All you do under this method is find a few assets similar to yours that were recently sold and evaluate the sale price. Average those prices to arrive at an approximate FMV.
Of course, this method breaks down if you can’t find similar assets or if the market’s going through changes.
Replacement Cost essentially looks at, well, how much it costs to replace the asset. This is technically a way to determine FMV, but it isn’t the best strategy.
Think about it: a newer version of your asset will obviously be worth more.
That said, Replacement Cost can help set an upper boundary to check against when using other methods. After all, your older asset can’t be worth more than the newest version of it.
For example, imagine you used another method to value an asset and found its FMV to be $10,000. However, you can get a new version of this asset (or a similar one) for $7,000. That indicates you may have miscalculated FMV and that you should try again.
Like selling a home, appraisal involves having an expert look at the asset in question and determine its FMV. You don’t really have to do any work here, aside from hiring the expert to take a look.
This is perhaps the most accurate method for determining FMV (other than listing your asset for sale), but you have to pay the appraiser.
The Bottom Line
FMV is vital to ensuring you gain the maximum value out of your assets and that your books are in order — not to mention valuing your entire business and figuring out some tax matters.
Comprehensive bookkeeping software solutions like ZarMoney make it easier to keep your books clean, track the FMV of your assets, and more accurately determine your business’ FMV. Try ZarMoney for free today.