What is Fair Value? (2024)

Fair value is a financial concept that is widely used in both investing and accounting to evaluate the true value of an asset. In this article, we are going to explore the meaning of fair value, how it is used, its advantages and the factors that affect it.

What is fair value?

Fair value refers to the intrinsic value of an asset, which is based on its fundamental characteristics instead of its market value. It is the price at which an asset would be exchanged between knowledgeable and willing parties who act independently — without any influence or bias.

The concept of fair value is widely used by investors and lending institutions to determine the true worth of a business and its assets. It allows them to make informed financial decisions that are in line with their objectives.

Fair value in investing

Investors typically use fundamental analysis to determine the fair value of a company’s stock and assess whether it is undervalued or overvalued.

A stock is deemed to be undervalued if its fair value is higher than its current market price. Undervalued stocks are generally preferred by investors due to their potential to appreciate in the future.

On the other hand, a stock is said to be overvalued if the fair value is lower than its current market price. Such stocks are preferred as strongly as undervalued assets since they are more likely to undergo price correction and depreciate in the future.

Here is an example to help you understand how you can use fair value in the context of the stock market.

Assume you are interested in investing in ABC Limited. The fair value of the company’s stock is Rs. 1,480, as ascertained through extensive fundamental analysis. However, the stock is currently trading at just Rs. 1,200.

Since the current market price is lower than its actual intrinsic fair value, you conclude that ABC Limited is undervalued and proceed to invest in it. Over time, the current market price steadily rises beyond its fair value to Rs. 1,800.

Now, since the current market value is higher than its fair value, you conclude that the stock of ABC Limited is overvalued and proceed to liquidate your investment. The total profit you get from this comes to Rs. 320 per share (Rs. 1,800 - Rs. 1,480).

Fair value in accounting

In fair value accounting, the price at which a company’s assets can be sold to a knowledgeable and willing buyer is recognised as their value. This is in contrast to the widely adopted practice of valuing assets by subtracting the depreciation from their original purchase price. Let us look at an example to understand how fair value accounting works.

Assume you are the owner of the company ABC Limited. Your company’s assets include a vehicle which was originally purchased a year ago at Rs. 10 lakh. The standard rate of depreciation for vehicles is 20%. Going by traditional accounting practices, the value of the vehicle in your financial statements must be Rs. 8 lakh [Rs. 10 lakh minus ( 20% of Rs. 10 lakh)].

However, since you have adopted the fair value accounting method, the value of the vehicle in your financial statements must be the price at which it can be sold to a knowledgeable and willing buyer — without any bias or influence.

Now, if the vehicle can only be sold for Rs. 7.5 lakh, you must recognise this selling price as the vehicle’s fair value in your financial statements.

Benefits of using fair value

Many companies choose to use fair value accounting practices due to the inherent advantages they offer. Here is a quick overview of some of the key benefits.

• Accuracy
  The use of fair value accounting practices ensures that the company always presents the true value of its assets and liabilities as on the date of the financial statements instead of historical or assumed value.
• Transparency
  Fair value accounting provides investors, lenders and other stakeholders with a verifiable and transparent measure of the assets and liabilities of a company. This enables them to make informed decisions based on accurate information.
• Adaptability
  Fair value accounting practices can be adapted to all kinds of assets and liabilities even if they are from a relatively new class or category.

Factors that can affect the fair value

The fair value of an asset is often influenced by a plethora of different factors. Let us explore a few key factors.

• Revenue and profitability
  The revenue and profitability of a company play a major role in determining its fair value. Stocks of companies with high revenues and profits tend to have high intrinsic values.
• Economic conditions
  The fair value also depends on the prevailing economic conditions. The values tend to be lower when the economy is in recession compared to when the economy is booming.
• Risk and volatility
  High-risk assets that are prone to volatile price movements generally have lower fair values compared to low-risk and stable assets.

Fair value vs market value

The fair value and the market value represent two different ways of valuing an asset. Here is a table outlining the key differences between these methods.

Conclusion

Whether it is used in accounting or investment analysis, fair value is one of the useful methods of valuing assets and liabilities. However, fair value assessments and investment decisions should be made with careful consideration of individual circ*mstances, risk tolerance, and financial goals. It is essential to conduct thorough research, including fundamental analysis, and consult with a qualified financial advisor before making any investment decisions. All investments involve risk, including the potential loss of principal, and past performance is not indicative of future results. The outcome of investments, including potential profits or losses, may vary based on market conditions and other factors beyond the control of the investor.