Fair Value: Definition, Formula, and Example

What Is Fair Value?

Fair value is the agreed price for an asset in a market transaction when a buyer and seller freely negotiate. It's a measure of an asset's current market value.

Fair value is determined by comparing recent transactions of similar assets and estimating expected earnings and replacement costs.

Fair value has application across various fields, such as accounting, futures trading, and stock investing.

Fair value helps assess the intrinsic worth of assets and liabilities, aiding investors and businesses in decision making.

Read to learn more about fair value, including formulas, examples, and benefits.

Comprehensive Overview of Fair Value

How Fair Value Influences Stock Investment Decisions

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 each investor's fair value estimate.

In investing, fair value is the price investors pay for desired growth and returns.

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 may forgo the purchase, as the market value does not align with their idea of fair value.

Applying Fair Value Concepts in Futures Trading

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 futures, fair value is the price where supply matches demand for a contract. It equals the spot price and considers interest and dividends lost in futures contracts.

Calculating Fair Value in Stock Index Futures

$\begin{aligned}&\text{Fair Value} = \text{Cash} \times \Big ( 1 + r \times \big ( \frac{ x }{ 360 } \big ) \Big ) - \text{Dividends} \\&\textbf{where:} \\&\text{Cash} = \text{Current value of security} \\&r = \text{Interest rate charged by broker} \\&x = \text{Number of days remaining in contract} \\&\text{Dividends} = \text{Number of dividends investor would} \\&\text{receive before expiration date} \\\end{aligned}$​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​

The Role of Fair Value in Accounting Practices

The International Accounting Standards Board defines fair value as the price to sell an asset or settle a liability.

Fair value accounting, or mark-to-market, calculates a company’s assets and liabilities at market value. In some instances, companies that hedge their assets might use hedge accounting, in which the value of the asset and its hedge are accounted as a single entry.

To do this, the accountant needs 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 when there is nothing compelling either the buyer or the seller to agree on a price. If a company is being liquidated, for example, its assets 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 affect the price.

If a construction business acquired a truck worth $20,000 in 2022 and decided to sell the truck in 2025, 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. 

Determining fair value is hard without an active market. 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 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.

Advantages of Using Fair Value in Financial Analysis

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 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 as 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.
  

Distinguishing Between Fair Value and 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.

Market value 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.

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.

Knowing a company’s fair value helps investors decide if a stock’s market value is high or low, guiding buy or sell decisions.

$\begin{aligned}&P = \frac{ D1 }{ r } - g \\&\textbf{where:} \\&P = \text{Current stock price} \\&D1 = \text{Value of next year's dividend} \\&g = \text{Constant growth rate expected} \\&r = \text{Required rate of return} \\\end{aligned}$​P=rD1​−gwhere:P=Current stock priceD1=Value of next year’s dividendg=Constant growth rate expectedr=Required rate of return​

The Bottom Line

Fair value is a key financial concept that reflects the price freely agreed upon by a buyer and a seller. Other factors, such as comparable asset prices, growth potential, and replacement cost, influence its determination.

Fair value plays a role in different areas, such as accounting (calculating a company’s assets and liabilities at market value), futures trading (determining the value of an underlying asset and the price at which supply matches demand for a contract), and stock investing (the price investors pay for a stock's desired growth and returns).

Fair value differs from market value in that fair value changes more slowly and is less influenced by market conditions than market value.

Benefits of fair value accounting include accuracy and adaptability, which provide a clearer view of a company's financial position.

Fair value in investment decision making helps investors identify overvalued or undervalued assets.