What a business valuation is | Business Appraisal

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iPhrase by phrase

The definition, under the glass

The ATO’s guide to market valuation for tax purposes quotes the International Valuation Standards Council’s definition and says it is consistent with the meaning Australian courts have given market value. It then takes the definition apart, phrase by phrase. Here are those phrases, in plain words.

“The estimated amount”: The most probable price reasonably obtainable on the valuation date: where the highest price a seller could reasonably get meets the lowest a buyer could reasonably pay. It leaves out prices pushed up or down by special terms, such as atypical financing, a sale and leaseback, or a concession from someone connected with the sale.
“On the valuation date”: The value belongs to one date. Markets change, so the same estimate may be wrong for another day.
“A willing buyer”: Reasonably informed and motivated, but not compelled to buy, not overeager, and not willing to pay more than the market requires.
“A willing seller”: Neither overeager nor forced to sell at any price, and not holding out for a price the market would not consider reasonable. The seller is hypothetical, so the actual owner’s own circumstances are not part of the picture.
“An arm’s length transaction”: No special or pre-existing relationship between the parties, such as parent and subsidiary companies or landlord and tenant, that could pull the price away from the market.
“After proper marketing”: The asset is assumed to have been put before the market in the most appropriate way to reach the best price reasonably obtainable.
“Knowledgeably, prudently”: Each side understands what the asset is, how it is used and could be used, and how the market stands. Prudence is judged at the valuation date, never with hindsight.
“Without compulsion”: Each party wants to deal, but neither is forced or unduly pushed into it.

One more idea sits underneath all of it. Market value reflects the asset’s highest and best use: the use that is possible, legally permissible and financially feasible, and that a market participant would have in mind when deciding what to bid. That may be the current use, or a different one.

iiValue and price

Why market value and price part company

A price is what two particular parties agreed. Market value is what the hypothetical, well-informed, unpressured pair would agree. When the real parties are related, rushed, or one of them gains something nobody else could, the two figures can drift apart.

Special value is the clearest case. Market value disregards attributes of an asset that are of value to one specific owner or buyer and not available to other buyers in the market, because the definition assumes a willing buyer, not a particular one.

business.gov.au puts the other side of it plainly when it talks about goodwill: each method gives a different answer, and what finally decides the value is the amount a buyer, or the market, will pay. A valuation estimates; a sale settles.

The ATO’s own example

The ATO describes a parent who sells a rental property to their son for $120,000, the amount still owing on the mortgage. A professional valuer puts the market value at the time of transfer at $450,000. For capital gains tax, the parent’s capital proceeds are $450,000, not the $120,000 that changed hands.

The rule at work is called market value substitution. It applies when what was received differs from market value and the two sides were not dealing at arm’s length. The ATO names two exceptions: on a transfer to a former spouse on the breakdown of a marriage or relationship the rule may not apply, and on a transfer for no payment to the trustee of a special disability trust any capital gain or capital loss can be disregarded. Read the example on the ATO’s site.

iiiNeighbours

Market value and its near neighbours

Several figures sit close to market value in a set of accounts. The ATO’s guide separates them.

How the ATO’s guide distinguishes these terms.
Term	What it means	Where it is used
Market value	The estimated amount on the valuation date between a willing buyer and seller at arm’s length.	Tax, unless a provision defines it differently.
Fair value	What selling the asset in an ordinary, orderly market sale would bring on the measurement date, as the accounting standard AASB 13 defines it.	Financial reporting. Not always identical to market value.
Historical cost	The original price paid, or the amount paid to produce the goods or services.	The ATO calls it conceptually distinct from market value.
A statutory market value	A value worked out under a rule written into a particular law.	For example, some employee share scheme and superannuation provisions.

ivLimits

What a valuation does not do

It does not audit the books. In APES 225, the standard for accountants who provide valuation services, a valuation is an estimate built from approaches and methods; checking that the underlying information is true sits outside it (see the definition of “Valuation” in section 2).
It does not look forward for tax. For tax purposes a market value is needed at the date the law specifies; the ATO says a prospective assessment for a future date will not be considered reasonable or acceptable.
It is not one-size-fits-all. The ATO notes that the tax law’s definition of market value does not give one meaning for every context, and particular provisions can set their own method or assumptions.

The next folio, Ways businesses are valued, looks at how an estimate is actually built.