|
What in the world
is fair market value?
By Daniel
Jimenez • Bankrate.com
While a seemingly simple term, fair market value is
perplexing to many novice investors because of the very looseness
of its meaning.
Fair market value is the final price at which two
interested parties agree to make a deal. Well, that's great, but
what does it mean? A trip to Anytown, U.S.A. may clarify matters.
Driving down Main Street, you spy a young entrepreneur
setting up a lemonade stand. The price: a nickel. Thirsty from your
trip, you buy a glass. You have now established that the fair market
value of the lemonade is five cents.
Now, let's suppose our young entrepreneur inspires
competition and a bevy of stands spring up on the same block. The
competitors decide to undercut the original salesman and offer their
product at two cents a glass, which you gladly accept. The fair
market value of lemonade has now been changed to two cents.
If, however, the streets of Anytown, U.S.A. suddenly
turn into the ravaged plains of the Serengeti, that same lemonade
might command as much as $10 per glass, as parched travelers compete
for the limited refreshment. Now the fair market value is $10.
Get it? Well, investments work in much the same way.
People often disagree about how much a stock or bond is worth based
upon perceived future earnings or market share. Interest rates,
market fluctuations and the law of supply and demand also affect
fair market value. In the end, though, it is simply the price at
which a buyer and seller agree to make a transaction.
Even if the seller or buyer is desperate to make a
deal (as was the case for those parched Serengeti travelers), fair
market value can still be reached.
A person might be so enamored of a stock -- because
of his belief about its future -- that he'll buy it even if the
price is high enough to give the shares a nosebleed. Or, if an investor
needs to unload a stock immediately because she owes money, she'll
sell it dirt cheap, even though the stock is "undervalued" at that
price. It still benefits her because she can pay off her debt with
the proceeds.
Fair market value transactions must be conducted at
arm's length -- meaning that both parties have something to gain
from the deal. Although the examples above may not seem "fair,"
indeed they are, since he believes he'll gain mucho in the future
and she will be able to pay off her debt.
However, suppose I offered to sell you a share of
Microsoft for just $5 because we're good friends (for that price,
you better have donated a kidney to me at some point). This would
not be considered an arm's-length deal because I'm selling you the
stock even though I don't stand to benefit as much as if I'd sold
it to the many buyers willing to pay the going rate. That's why
investors in companies that are acquisition targets get upset when
the management takes a lower-priced offer that might be better for
them than for shareholders.
The Serengeti, lemonade stands, and Microsoft shares
-- why's fair market value so hard to understand? Sometimes, the
simplest concepts are the cloudiest.
-- Posted: Nov. 24, 1999 |
