Investment value and fair market value are closely related but ultimately different valuation concepts. It is possible an asset's investment value is the same as its market, or "fair market," value, but it is more likely its investment value is higher or lower than market value depending on who is doing the bidding. Put another way, market value is relatively steady and uniform, while investment value is unpredictable and varied, completely dependent on the potential buyer.
At a fundamental level, the difference between fair market value and investment value boils down to a matter of perspective. Fair market value reflects an asset on a stand-alone basis, which is to say it is independent of ownership and should be seen in terms of broader market conditions. For example, the fair market value of a factory does not change, in theory, depending on which specific firm operates the factory. Conversely, investment value represents an asset's value once ownership is considered. This includes possible synergies, goodwill from brand recognition or other owner-specific values.
Perhaps most importantly, any active participant in the market can realize the same fair market value. This is not true for investment value, which is unique to every investor. Individual investors, or small classes of investors, may receive special discounts or realize premiums for specific assets.
There are many conflicting interpretations of investment value and fair market value in the world, largely thanks to the many different legal jurisdictions in which investors have to comply. In fact, many cannot even agree on the proper terminology. For example, the terms "fair value" and "fair market value" often mean the same thing but not always. Some jurisdictions lump both terms together under the broader umbrella of "market value" or "neutral value."
These competing definitions have very real implications for lots of professionals. Accountants rely on fair market value when constructing financial statements, and a uniform definition is necessary to allow for comparisons between firms.
Through 2010, American firms used a different definition of fair value than the rest of the world. This was solved in May 2011, when the International Accounting Standards Board (IASB) issued a statement titled "Fair Value Measurement," and the American Fair Accounting Standards Board (FASB) issued the "Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRS" paper, helping to bridge the gap between the two systems.
The new legal accounting definition for both generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) is the "price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."
As it pertains to property, fair market value is established by The American Society of Appraisers (ASA). It defines fair market value as the "price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market," among other qualifications.
There are fewer strict definitions of investment value, although International Valuation Standards uses "the value of an asset to the owner or a prospective owner for individual investment or operational objectives." Put simply, this means an investment's value is based on its expected usefulness to the owner/buyer.
Coming up with an accurate investment value is partially subjective and imperfect, and there are countless examples of how the same investment might be valued differently based on who is buying it. For instance, shares of company stock are probably less valuable to a brand-new investor than to an investor on the verge of gaining a majority stake.
Consider two companies competing over the same asset, such as a factory or plot of land. The larger company may be able to achieve greater economies of scale than the smaller company, and thereby realize a higher rate of return on the investment. In such a circumstance, it does not make any sense to just look at the fair market value of the asset since anticipated future cash flows are different for different bidders.
These distinctions occur because of the synergies between a unique investment and a unique investor, often resulting in a premium to the fair market value. In the previous example of the two firms, the larger company applies a larger synergistic premium to the value of an investment.
Imaginary Markets and Real People
Some in the finance world consider fair market value to be an academic exercise, and not a particularly useful one. The criticism is not entirely unwarranted; fair market value relies on abstract economic concepts such as "unregulated markets" or "willing buyers and sellers" who are "well informed" about the trade.
In fact, the U.S. Department of Labor uses a 131-word working definition of fair market value under Revenue Ruling 59-90, including nine essential elements and eight basic factors. One such element notes fair market value is "paid in terms of money or money's worth," or a cash-equivalent, which is practically inapplicable to transactions such as stock-for-stock acquisitions.
Fair market value assumes a great deal of working knowledge on behalf of appraisers, attorneys, traders, accountants and employee stock ownership plan (ESOP) participants, etc. In reality, such knowledge is highly specialized and often unnecessary. For this reason, many prefer investment value whenever possible.
Investment value is much less demanding. An individual investor/buyer is likely to know his own tax rate, financing capabilities and, if applicable, business strengths. This makes it relatively straightforward to estimate future cash flows and the expected useful life/holding period for the asset at hand.
Perhaps the most damning description of fair market value's limitations comes from the appraiser course book of the Internal Revenue Service (IRS), which notes "the consideration of any valuation case would ensure that both sides, including their respective appraisers, if any, are employing the correct definition and criteria for determining fair market value. No case is stronger than its weakest link and if the wrong valuation standard is applied, the conclusion will be defective." In other words, fair market value only works if both sides fully understand, and accurately apply, the regimented definition of fair market value.