What Is Fair Value?
Fair value is the estimated price at which an asset is bought or sold when both the buyer and seller freely agree on a price.
To determine the fair value of a product or financial investment, an individual or business may look at actual market transactions for similar assets, estimate the expected earnings of the asset, and determine the cost to replace the asset.
- Fair value is the estimated price at which an asset is bought or sold when both the buyer and seller freely agree on a price.
- Individuals and businesses may compare current market value, growth potential, and replacement cost to determine the fair value of an asset.
- Fair value is a measure of an asset's worth and market value is the price of an asset in the marketplace.
- Fair value accounting is the practice of measuring a business's liabilities and assets at their current market value.
Understanding Fair Value
Fair Value in Investing
A common way to determine a stock's fair value is to list it on a publicly-traded stock exchange. As shares trade, investor demand creates the appropriate bid and ask prices, or market value, and influences an investor's fair value estimate.
An investor can compare their fair value estimate with the market value to decide to buy or sell. The fair value is often the price that an investor pays that will generate their desired growth and rate of return.
If the fair value of a stock share is $100, and the market price is $95, an investor may consider the stock undervalued and buy the stock. If the market price is $120, the investor will likely forego the purchase as the market value does not align with their idea of fair value.
The fair value of a derivative is determined by the value of an underlying asset. When an investor buys a 50 call option, they are buying the right to purchase 100 shares of stock at $50 per share for a specific period. If the 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 or the point where the supply of goods matches demand. This is equal to the spot price and accounts for compounded interest and lost dividends resulting from the futures contract ownership versus a physical stock purchase.
Fair Value of Stock Index Futures
Fair Value=Cash×(1+r×(360x))−Dividendswhere:Cash=Current value of securityr=Interest rate charged by brokerx=Number of days remaining in contractDividends=Number of dividends investor wouldreceive before expiration date
Fair Value in Accounting
The International Accounting Standards Board recognizes the fair value of certain assets and liabilities as the price at which an asset can be sold or a liability settled. Fair value accounting, or mark-to-market accounting, is the practice of calculating the value of a company’s assets and liabilities based on the current market value.
To do this, you will need to consider:
- Current market: The fair value of an asset or liability is what it is worth in the current market. It doesn't matter what an asset would have sold for two years ago; its fair value is what it is worth today.
- Voluntary vs. involuntary transactions: Fair value applies in orderly transactions where there is nothing compelling either the buyer or the seller. If a company is being liquidated, for example, items will not be sold at fair value.
- Seller's intentions: When and how you intend to sell an asset or settle a liability can impact its fair value. If you need to sell an asset quickly, for example, you will probably not use fair value accounting.
- Arms-length transactions: In fair value accounting, the transaction should be an arms-length transaction between the seller and an independent third party. Fair value accounting would not apply to a business partner or relative, as these relationships can alter the transaction.
If a construction business acquired a truck worth $20,000 in 2019 and decided to sell the truck in 2022, comparable sale listings of the same used truck may include two trucks priced at $12,000 and $14,000. The estimated fair value of the truck may be determined as the average current market value, or $13,000.
It is difficult to determine a fair value for an asset if there is not an active market for it. Accountants will use discounted cash flows will determine a fair value by determining the cash outflow to purchase the equipment and the cash inflows generated by using the equipment over its useful life.
Fair value is also used in a consolidation when a subsidiary company’s financial statements are combined or consolidated with those of a parent company. 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.
Benefits of Fair Value
Fair value measures the real or estimated value of an asset or liability. Fair value accounting is widely used in business and investing because of its benefits. These include:
- Adaptability: Fair value can be adapted to apply to all types of assets and liabilities; if the asset exists, its fair value can be determined. Historical valuations, on the other hand, are less accurate, because an asset or asset class might not have existed in the past.
- Accuracy: Valuations made with fair value accounting have a high level of accuracy because they change when prices move up or down.
- Actual income: When a business uses fair value accounting, the total asset value reflects the actual income of the company. This can provide a more reliable picture of a company's financial position than a statement of profit and loss, which can be manipulated.
- Asset reduction: Fair market accounting allows a business to practice asset reduction, which is declaring that the value of an asset in a sale was overestimated or overstated. This can help businesses weather financial difficulties.
Fair Value vs. Market Value
Fair value is a broad measure of an asset's intrinsic worth. It requires determining the right price between two parties depending on their interests, risk factors, and future goals for the asset. Fair value is most often used to gauge the true worth of an asset by looking at factors like its potential for growth or the cost to replace it.
Market value is the observed and actual value for which an asset or liability is exchanged. It reflects the current value of the investment as determined by actual market transactions. It can fluctuate more frequently than fair value. Market value is also highly dependent on supply and demand. For example, housing prices are often dependent on the number of houses for sale in an area (supply) and how many buyers are currently looking (demand) as much as the intrinsic value of the house.
Influenced by growth potential and replacement cost
Reflects the intrinsic value
Influenced by supply and demand
Determined by current market transactions
For example, a stock's market value can move up and down quickly depending on a variety of external factors. But the fair value of a company changes much more slowly. Investors who know a company's fair value can use that to decide whether the market value of a stock is high (which means it's a good time to sell) or low (which means its a good time to buy).
What Is the Intrinsic Value of a Stock?
Fair value is the price an investor pays for a stock and may be considered the present value of the stock, when the stock's intrinsic value is considered and the stock's growth potential. The intrinsic value is calculated by dividing the value of the next year’s dividend by the rate of return minus the growth rate.
P=rD1−gwhere:P=Current stock priceD1=Value of next year’s dividendg=Constant growth rate expectedr=Required rate of return
How Is Fair Value Considered In the Accounting of Financial Assets?
Generally Accepted Accounting Principles and International Financial Reporting Standards use fair value in accounts comprised of derivatives and hedges, employee stock options, and financial assets and accept that financial markets are efficient and their prevailing prices are reliable measures of fair value.
How Does the Securities and Exchange Commission Regulate Fair Value?
In 2020, the SEC implemented rule 2a-5 under the Investment Company Act of 1940 requiring funds to value their portfolio investments using the market value of their portfolio securities when market quotations are “readily available.” If data is not readily available or if the investment is not a security, the Act requires the fund to use the investment’s fair value.
The fair value is determined in good faith by the fund’s board who are required to establish fair value methodologies and oversee pricing services.
What Is Historical Cost Accounting?
Fair value accounting measures assets and liabilities at estimates of their current value whereas historical cost accounting measures the value of an asset based on the original cost of an asset.
What Methods Are Used to Determine Fair Value?
A market approach uses the prices associated with actual market transactions for similar assets to derive a fair value. An income approach uses estimated future cash flows or earnings to determine the present value fair value. A cost approach uses the estimated cost to replace an asset to help find an item's fair value.
The Bottom Line
Fair value is the estimated price at which an asset is bought or sold when both the buyer and seller freely agree on a price. Individuals and businesses may compare current market value, growth potential, and replacement cost to determine the fair value of an asset. Fair value calculations help investors make financial choices and fair value accounting practices determine the value of assets and liabilities based on current market value.