What is 'Fair Value'
Fair value is defined as a sale price agreed to by a willing buyer and seller, assuming both parties enter the transaction freely. Many investments have a fair value determined by a market where the security is traded. Fair value also represents the value of a company’s assets and liabilities when a subsidiary company’s financial statements are consolidated with a parent company.
BREAKING DOWN 'Fair Value'
The most reliable way to determine an investment’s fair value is to list the security on an exchange. If XYZ stock trades on an exchange, market makers provide a bid and ask price for XYZ stock. An investor can sell the stock at the bid price to the market maker and buy the stock from the marker maker at the ask price. Since investor demand for the stock largely determines bid and ask prices, the exchange is the most reliable method to determine a stock’s fair value.
How a Consolidation Works
Fair value is also used in a consolidation, which is a set of financial statements that presents a parent company and a subsidiary firm as if the two businesses are one company. This accounting treatment is unusual because original cost is used to value assets in most cases. The parent company buys an interest in a subsidiary, and the subsidiary’s assets and liabilities are presented at fair market value for each account. When the accounting records of both companies are consolidated, the subsidiary company’s fair market values are used to generate the combined set of financial statements.
Factoring in a Valuation
In some cases, it may be difficult to determine a fair value for an asset if there is not an active market for trading the asset. This is often an issue when accountants perform a company valuation. Say, for example, an accountant cannot determine a fair value for an unusual piece of equipment. The accountant may use the discounted cash flows generated by the asset to determine a fair value. In this case, the accountant uses the cash outflow to purchase the equipment and the cash inflows generated by using the equipment over its useful life. The value of the discounted cash flows is the fair value of the asset.
The fair value of a derivative is determined, in part, by the value of an underlying asset. If you buy a 50 call option on XYZ stock, you are buying the right to purchase 100 shares of XYZ stock at $50 per share for a specific period of time. If XYZ stock’s market price increases, the value of the option on the stock also increases.
In the futures market, fair value is the equilibrium price for a futures contract. This is equal to the spot price after taking into account compounded interest (and dividends lost because the investor owns the futures contract rather than the physical stocks) over a certain period of time.