Fair value: What it is and how to calculate it

Fair value is the estimated price at which an asset is bought or sold when the buyer and seller freely agree on a price. A common way to determine the fair value of a stock is to list it on a public stock exchange. Let's look at the benefits of calculating fair value and how to apply it to our stock investment strategy.

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, an individual or company can look at actual market transactions of similar assets, estimate the expected benefits of the asset, and determine its replacement cost.

How value is determined reasonable

A common way to determine the fair value of a stock is to list it on a public stock exchange. As stocks are traded, investor demand creates the appropriate buying and selling prices, or market value, and influences an investor's estimate of fair value. An investor can compare his or her estimate of fair value with the market value to decide to buy or sell. Fair value is typically the price an investor pays that will generate the desired growth and rate of return. For example, if the fair value of a share is £7.02 and the market price is £4.81, an investor may consider the share to be undervalued and buy it. If the market price is £9, the investor is likely to give up on the purchase, as the market value does not fit their idea of ​​fair value.

bar graph

Fair value of a publicly traded stock. Source: Simplywall.st.

Value calculation formula reasonable

The fair value of a derivative is determined by the value of an underlying asset. Fair value is the equilibrium price of a futures contract or the point at which the supply of goods matches the demand. This is equal to the spot price and represents the compound interest and lost dividends resulting from owning the futures contract versus physically purchasing the stock.

formula

Formula for calculating the fair value of a derivative

Benefits of fair value calculation

Fair value measures the actual or estimated value of an asset or liability. Fair value accounting is widely used in business and investment due to its advantages. 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. In contrast, historical valuations 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 accuracy because they change when prices rise or fall.
  • Actual income: When a company uses fair value accounting, the total value of assets reflects the company's actual income. This can provide a more reliable picture of a company's financial position than a profit and loss statement, which can be manipulated.
  • Reduction of assets: Fair market accounting allows a company to practice asset write-downs, which is declaring that the value of an asset in a sale was overstated or understated. This can help companies overcome financial difficulties.

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