The fair market value (of a good or service being exchanged) refers to the price at which both transacting parties (the buyer and the seller of that good or service) have agreed to independently.
If certain conditions are met, the fair market value will represent an accurate valuation of the goods being exchanged. The conditions are as follows:
There shall be no asymmetries of information. It means that both parties must be equally and reasonably knowledgeable about the asset or good in question.
Both parties must be perfect logisticians and economic agents. It means that they must behave in their own self-interest.
Both parties must be free of any undue pressure to execute the transaction.
A reasonable amount of time must be available to execute the transaction.
The abovementioned conditions are economic principles that determine the degree of freedom and openness in any market activity. Therefore, fair market value is different from market value, which is the current price of a given asset in a given marketplace. For example, the price of Treasury bills allotted via a competitive bidding process does not reflect their fair market value.
Significance of Fair Market Value
1. Legal situations
In the event of a divorce settlement or payment of damages due to harm caused to private property, the fair market value of the asset in question is used.
Fair market value is used to assess the municipal property taxes to be paid by an owner. Tax deductions are also available on casualty loss and depreciation of assets. In cases of charitable donations, the fair market value of the donation is used for tax purposes. Therefore, a taxpayer can claim a tax credit for the fair market value of the donation made.
The process of price discovery employed by professionals in such a situation is known as appraisal. However, fair market value is different from appraised value as the latter represents the worth of the good from only one party’s point of view.
Fair market value is also determined in cases of insurance claims. If an insured vehicle gets damaged, the insurance claim is proportional to the current fair market value of the vehicle and not the price at which the vehicle was originally bought.
What is an Appraisal?
An appraisal refers to the process of valuation of any asset: a property, good, or business. It is used to determine the selling price of assets or to calculate tax liabilities. A variety of methods can be used by appraisers for price discovery. Such methods include risk analysis and comparing the current market value of similar objects.
For companies, fair market value refers to the accepted current value of one share of the company’s total stock. It is different from the overall valuation of a company, which includes all its assets and liabilities.
The fair market value of a public company’s stock can be calculated by averaging its highest selling price and the lowest selling price in one trading day. For private companies, the same is done by comparing the valuation ratios of private companies to that of public companies.
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