A thorough understanding of financial valuation concepts is a requisite foundation for a well-reasoned and defensible valuation analysis.¹ At the outset of each valuation engagement, it is critical to appropriately define the standard of value and premise of value to be employed in developing the valuation opinion.² The standard of value defines the type of value to be determined and answers the question, “value to whom?”

The premise of value defines the hypothetical terms of the sale, i.e., “…the most likely set of transactional circumstances that may be applicable to the subject valuation; e.g., going concern, liquidation,”³ and answers the question of “value under what further defining circumstances?”

The selection of the premise of value can have a significant effect on its application in the valuation process. Two general concepts relate to the consideration and selection of the premise of value: (1) value in use; and, (2) value in exchange. An important concept that impacts the selection of the appropriate premise of value is that of highest and best use.

For example, in the absence of a reasonable expectancy of sufficient economic cash flow to support the value of the investment represented by the tangible assets utilized to generate the revenue stream of the enterprise, the highest and best use of the assets may be under, and the appraiser may select, a premise of value of “Value-in-exchange as an orderly disposition of a mass assemblage of assets, in place”, which includes all individually identifiable tangible and intangible assets. ⁴ 

The concept of highest and best use is defined as:

“…that use among possible alternatives which is legally permissible, socially acceptable, physically possible, and financially feasible, resulting in the highest economic return.”⁵

As Dr. Pratt points out, the concept of highest and best use drives the selection of the valuation premise, which may apply under the Standard of Value of Fair Market Value, to wit:

“Each of these alternative premises of value may apply under the same standard, or definition, of value.  For example, the fair market value standard calls for a ‘willing buyer’ and a ‘willing seller.’  Yet, these willing buyers and sellers have to make an informed economic decision as to how they will transact with each other with regard to the subject business.  In other words, is the subject business worth more to the buyer and the seller as a going concern that will continue to operate as such, or as a collection of individual assets to be put to separate uses?  In either case, the buyer and seller are still ‘willing.’  And, in both cases, they have concluded a set of transactional circumstances that will maximize the value of the collective assets of the subject business enterprise.”⁶ [Emphasis added]

Dr. Pratt goes on to explain that:

“…[t]ypically, in a controlling interest valuation, the selection of the appropriate premise of value is a function of the highest and best use of the collective assets of the subject business enterprise.  The decision regarding the appropriate premise of value is usually made by the appraiser, based upon experience, judgment and analysis.” [Emphasis added]

Other guidance related to the concept of highest and best use can be found in the Uniform Standards of Professional Appraisal Practice (USPAP), as promulgated by The Appraisal Standards Board of The Appraisal Foundation, which is a codification of the standard practices to be utilized within the practice of appraisal and was created for the purpose of promoting and maintaining a high level of public trust in appraisal practice by establishing requirements for appraisers.⁷

According to Standards Rule 9-3 of USPAP:

“In developing an appraisal of an equity interest in a business enterprise with the ability to cause liquidation, an appraiser must investigate the possibility that the business enterprise may have a higher value by liquidation of all or part of the enterprise than by continued operation as is.”⁸ [Emphasis added]

This point is further elucidated in the comment to Standard 9-3:

“This Standards Rule requires the appraiser to recognize that the continued operation of a business is not always the best premise of value because liquidation of all or part of the enterprise may result in a higher value.”⁹ [Emphasis added]

As illustrated above, the highest and best use of the invested capital in a given enterprise may not be in its continued use as a going concern but may, in fact, be in-exchange, either as an orderly disposition of the assets or in liquidation.  In either sense, it should be noted that the decision to utilize the premise of value in-exchange, in contrast to that of value in-use, does not preclude the existence of a requisite valuation of the value of intangible assets. Intangible assets may well exist and hold significant economic value in exchange.

As stated by James Zukin:

“The underlying asset approach considers the component parts of a business enterprise…[and] can be [performed] on either a net liquidation basis or by using the value of the underlying assets in continued use. The former basis is normally applicable when there is a distinct possibility that the business is worth more ‘dead’ than ‘alive.’ While the latter basis is normally applicable when there is little possibility of liquidation.” ¹⁰

Zukin goes further in clarifying the existence of intangible assets by stating:

“…the market value [of a business enterprise] cannot be lower than the net liquidation value of the [enterprise’s underlying assets]…and [a]nother asset area requiring examination [when using the underlying asset approach] is [including the value of] the separately identifiable intangible assets.” ¹¹

The historical use of the assets comprising a healthcare enterprise, e.g., a physician practice, should provide no binding pre-supposition about the utility to be derived by a typical purchaser from the ownership of one or more of the subject assets.  The historical inability of a particular owner to generate a positive net cash flow emanating from the subject asset(s) does not require (nor even imply) that a typical investor in a similar asset(s) would be likewise incapable of utilizing it to produce a positive stream of economic benefit.  Investors may acquire assets, such as intangible assets, under different settings and circumstances which are not beholden to the current use of the assets by the seller of the subject intangible assets, or the current owner’s difficulties in generating positive net economic benefit from the enterprise in its entirety. 

The diversity in uses for assets among purchasers and sellers is an economic fact which gives rise to the difference in anticipated benefit to be derived from the ownership of the subject asset and the opportunity of the participants in a transaction to generate gains from trade. In fact, it is the existence of these differences in value, i.e., the aggregate expected economic benefit accruing to the owner of a particular asset, which underpins the concept of “willing buyer” and “willing seller.” ¹²

The expected future economic benefit accruing to the purchaser of a subject asset will tend to put a ceiling on the price the acquirer would be willing to pay.  Likewise, the expected future economic benefit accruing to the seller of an asset will tend to put a floor on the price the seller would be willing to accept.  Within the gap between the expected future economic benefits of the buyer and seller lies the gains of trade, which may be distributed between the market participants to arrive at the agreed upon transaction price for the subject asset. 

According to the theory of utility maximization, rational market participants tend to make decisions in order to maximize their own expected personal utility,¹³  with further assumptions pertaining to each participant’s decision making criterion, to wit:

1. Perfect rationality (e.g., in that they prefer more benefit to less); ¹⁴
2. Perfect self-interest (i.e., the decisions people make are based solely on the consequences to themselves); ¹⁵ and,
3. Perfect information (i.e., an equivalency of knowledge between the parties of all information pertinent to the transaction, which is a key criterion in the definition of Fair Market Value). ¹⁶

This concept of utility maximization was described by Jeremy Bentham (regarded as the founder of modern utilitarianism), as being based on the premise that utility derived from an object is its ability to:

“…produce benefit, advantage, pleasure, good, or happiness or prevent the happening of mischief, pain, evil, or unhappiness to the party whose interest is considered.”¹⁷

Therefore, while value is a forward looking concept, market participants will vary in their opinions as to the utility to be derived from ownership or control of an asset.  The job of the valuation analyst is to consider each of the appropriate concepts that provide insight and guidance to value, which, in addition to the appropriate standard of value, includes the consideration of the highest and best use of the assets of the enterprise, which informs the valuation analyst’s selection of an appropriate premise of value.