Fair value represents the true worth of an asset, such as a product, stock, or security, as mutually agreed upon by both the buyer and the seller. It applies to assets being traded under normal market conditions within their respective markets, rather than in liquidation scenarios. The purpose of fair value is to establish a price that is equitable for both parties, ensuring the buyer receives a just valuation while the seller does not incur a loss.
For example, the fair value of securities is determined by the market price at which they trade. In accounting, fair value is used to measure the approximate worth of a company's assets and liabilities on its financial statements.
What is fair value?
Fair value represents the agreed-upon price between a willing buyer and seller for an asset under normal market conditions. This valuation is applicable to assets actively traded in their respective markets and does not encompass forced liquidation scenarios.
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.
Particulars |
Fair value |
Market value |
Representation |
Represents the true intrinsic value of an asset |
Represents the price at which an asset can be immediately bought or sold on the market |
Valuation |
Dictated by the fundamentals of the asset |
Dictated by the forces of demand and supply |
Frequency of change |
Does not change frequently |
Changes frequently based on the forces of demand and supply |
Accuracy |
Highly accurate |
Not very accurate |
Application |
Widely used in accounting and investing |
Only used in investing |
Fair value vs carrying value
Fair value and carrying value are distinct accounting concepts used to assess the value of assets.
Fair Value represents the estimated price at which an asset could be sold in a current market transaction between willing parties. It involves considering factors such as profit margins, future growth potential, and associated risks.
Carrying Value, also known as book value, is the amount at which an asset is reported on a company's balance sheet. It is calculated by subtracting accumulated depreciation and impairment losses from the asset's original cost.
Note: Carrying value reflects the asset's value based on its historical cost and subsequent adjustments, not its current market price.
Example
Company A purchases a backhoe for Rs. 22,50,000 (assuming $1 = Rs. 85). If the backhoe's useful life is 10 years with annual depreciation of Rs. 1,50,000, its carrying value after 10 years would be:
Carrying Value = Rs. 22,50,000 - (Rs. 1,50,000 x 10) = Rs. 7,50,000
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 circumstances, 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.
