Fair value: definition, formula and example (2023)

What is fair value?

Fair value is the estimated price at which an asset is bought or sold when the buyer and seller freely agree on a price.

To determine the fair value of a financial product or investment, a person or company can analyze actual market transactions for similar assets, estimate the expected earnings on the asset, and determine the cost to replace the asset.

Understand fair value

Fair value of the investment

A common way to determine the fair value of a stock is to list it on a stock exchange.Stock Exchange. As shares trade, investor demand creates the appropriate purchase and sale prices, or market value, and influences the investor's estimate of fair value.

An investor can compare his estimate of fair value with the market value to decide whether to buy or sell. Fair value is generally the price an investor pays to generate the desired growth and rate of return.

If the fair value of a stock is $100 and the market price is $95, an investor might consider the stock undervalued and buy it. If the market price is $120, the investor is likely to forego the purchase since the market value does not align with his idea of ​​fair value.

The fair value of aderivativeit is determined by the value of an underlying asset. When an investor buys a 50 call option, he is buying the right to buy 100 shares at $50 per share during a specified period. If the market price of the stock increases, the value of the stock option will also increase.

Nofuturesmarket, fair value is the equilibrium price for a futures contract or the point at which the supply of goods matches the demand for it. this is equal tocounted priceand accounts for compound interest and lost dividends resulting from ownership of the futures contract versus a physical purchase of shares.

Fair value of stock index futures

$\begin{aligned}&\text{Fair Value} = \text{Money} \times \Big ( 1 + r \times \big ( \frac{ x }{ 360 } \big ) \Big ) - \text{Dividends } \\&\textbf{where:} \\&\text{Money} = \text{Current value of the security} \\&r = \text{Interest rate charged by the brokerage firm} \\&x = \text {Number of days remaining in the contract} \\&\text{Dividends} = \text{Number of dividends the investor would receive} \\&\text{will receive before the expiration date} \\\end{aligned}$​fair value=Money×(1+r×(360X​))−dividendswhere:Money=current safe valuer=Interest rate charged by the brokerX=Number of days remaining on the contractdividends=Number of dividends the investor would makereceive before expiration date​

Fair value in accounting

OInternational Accounting Standards Boardrecognizes the fair value of certain assets and liabilities as the price at which an asset could be sold or a liability settled. fair value accounting, ormark to marketAccounting is the practice of calculating the value of a company's assets and liabilities based on their 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 how much an asset would have sold two years ago; its fair value is what it is worth today.
• Voluntary vs. involuntary: Fair value is applied in orderly transactions in which there is nothing binding on the buyer or seller. If a business is liquidated, for example, the items will not be sold at their fair value.
• seller's intentions: When and how you intend to sell an asset or settle a liability can affect its fair value. If you need to sell an asset quickly, for example, you probably don't use fair value accounting.
• arms transactions: In fair value accounting, the transaction must be a market transaction between the seller and an independent third party. Fair value accounting would not apply to a business partner or relative, as these relationships could change the transaction.

If a construction company bought a truck worth $20,000 in 2019 and decided to sell it in 2022, comparable sales listings for the same used truck might include two trucks priced at $12,000 and $14,000. The estimated fair value of the truck can be determined as the current median market value, or $13,000.

It is difficult to determine the fair value of an asset if there is no active market for it. Accountants will usediscounted cash flowsIt will determine the fair value by determining the cash outflow to purchase the equipment and the cash inflows generated by the use of the equipment during its useful life.

Fair value is also used in aconsolidationwhen the financial statements of a subsidiary are combined or consolidated with those of a parent. The parent purchases an interest in a subsidiary and the assets and liabilities of the subsidiary are stated at fair market value for each account.

fair value earnings

Fair value measures the actual or estimated value of an asset or liability. Fair value accounting is widely used in business and investment 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 may not have existed in the past.
• Precision: Valuations made using fair value accounting have a high level of precision because they change when prices rise or fall.
• actual income: When a company uses fair value accounting, the total value of assets reflects the actual income of the company. This can provide a more reliable picture of a company's financial position than a profit and loss statement, which can be manipulated.
• asset reduction: Fair market accounting allows a company to practice asset write-down, which is declaring that the value of an asset at a sale has been overstated or overstated. This can help businesses facing financial difficulties.
  

Fair Value x Market Value

Fair value is a broad measure of an asset's intrinsic value. It requires determining the fair price between two parties, depending on their interests, risk factors, and future goals for the asset. Fair value is most often used to assess the true value of an asset, looking at factors such as its growth potential or the cost to replace it.

Market valueIt 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. May fluctuate more frequently than fair value. The market value also depends a lot on supply and demand. For example, home prices often depend on the number of homes for sale in an area (supply) and how many buyers are currently looking (demand), as well as the intrinsic value of the home.

For example, the market value of a stock can rise and fall rapidly depending on a variety of external factors. But the fair value of a company changes much more slowly. Investors who know the fair value of a company can use it to decide if a stock's market value is high (meaning it's a good time to sell) or low (meaning it's a good time to buy). .

$\begin{aligned}&P = \frac{ D1 }{ r } - g \\&\textbf{where:} \\&P = \text{Current share price} \\&D1 = \text{Next year of amount dividend} \ \&g = \text{Expected constant growth rate} \\&r = \text{Required rate of return} \\\end{aligned}$​PAG=rD1​−gramwhere:PAG=current stock priceD1=Next year's dividend amountgram=expected constant growth rater=return fee required​

Conclusion

Fair value is the estimated price at which an asset is bought or sold when the buyer and seller freely agree on a price. Individuals and businesses can compare current market value, growth potential, and replacement cost to determine the fair value of an asset. Fair value calculations help investors make financial decisions, and fair value accounting practices determine the value of assets and liabilities based on current market value.