What is fair value?

Definition:

The fair value of an investment is a representation of what the investment is expected to sell for in a fair and competitive market. It is important to distinguish between fair value and market value as they are similar but not the same thing.

How does fair value work?

Before we proceed to determining fair value, it is important to understand that the fair value of an investment is an estimated or potential value and requires certain assumptions. It is not an accurate calculation of the true value of the investment. If the assumptions you make differ from reality or from someone else’s estimates, then your fair value estimate will be different.

Determining the fair value of an investment

To see how this works, let’s take a look at the following equation using a simple example.

The intrinsic value of a stock is calculated by dividing the expected dividends for the next year by the required rate of return minus the growth rate.

P = D1 / r – g

(Here, P = current stock price, D1 = expected dividends for the next year, g = expected constant growth rate, and r = required rate of return.)

Let’s assume that the stock in question is expected to pay a dividend of $2, the discount rate is 8%, and the expected growth rate is 6%. The fair value of the stock is $100.

But what are the estimates that go into estimating future dividends, discount rates, and expected growth rates?

Future dividends can be estimated based on the company’s history of dividends and considering how earnings have grown over time. This can give you an expected growth rate for earnings (g), and you can also use this information to calculate the next period’s dividend (D1).

For example, let’s assume you are looking at the last five years of dividends and see that they have grown at an average rate of 6% per year. Assuming you reasonably expect this rate to continue in the future, you can set g at 6%. The last dividends will increase by 6% and become D1. In our example, let’s assume the last dividend was $1.89. Because we expect it to grow by 6% over the next year, the expected dividend for the next period would be 1.89 × 1.06 = $2.

What about the discount rate? The discount rate can also be considered as the required rate of return for the investor.

Several factors influence the required rate of return, such as the interest rate you can earn on risk-free government bonds, expected inflation, liquidity, and the level of risk associated with the investment. The more favorable these factors are for the investor, the lower the required rate of return; and the less favorable they are, the higher the required rate of return. In our hypothetical example, let’s say that based on our assessment of each of these factors, we should believe that we can earn 8% by investing in the stock or we wouldn’t do it.

Fair value vs. market value

Fair value is an estimate of what the investment might be worth in a competitive and free market. Market value is the current value of the investment as determined by actual market transactions, and therefore can fluctuate more than fair value. Fair value is also calculated based on a chosen estimation model such as the discounted cash flow model, which requires the investor to make some assumptions about the inputs of the model. While market value is an actual observed value, it does not require any assumptions.

Fair value Market value

Hypothetical or estimated value Actual value or current price

Calculated using an observed model in the market Requires assumptions does not require any assumptions

What does fair value mean for individual investors?

Fair value estimation gives you a way to determine the long-term intrinsic value of a particular investment so you can decide whether this investment is one you want to buy or sell if you already own it.

It is used by

By comparing the fair value of an investment with the current market price. Using our example again where we estimate the fair value of a stock at $100, we will get a current price quote for this stock. If it is less than $100, for example $92.50, then this analytical method will indicate that this is a stock we want to buy because its current market price is below its estimated value. On the other hand, if the current market price is above $100, for example $104.75, we will not buy it because it is currently valued as high.

To clarify that this is just an estimate and that the assumed values of your inputs have a significant impact on determining the fair value of the stock, let’s see what happens when one of the inputs is changed.

The concept of fair value for an investment is merely an estimate based on a theoretical model with estimated inputs. It should not be considered an accurate measurement of the actual value of the investment.

Let’s assume you change your mind and decide that the investment is riskier than you originally thought. Instead of a required rate of return of 8%, you decide that 9% is more appropriate. This means that you now value the stock at only $66.67.

This is a significant difference. Now, even at a price of $92.50, you would reject this investment based on this model. Why? Because you would have to pay $92.50 for something that you now estimate to be worth only $66.67. It is no longer worth the price.

Was this article helpful?

Thank you for your feedback!

Sources:

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we ensure accuracy, reliability, and quality in our content.

AICPA. “Quick Reference Guide, Standards and Foundations of Value.”

Valuation Masterclass. “What is the Gordon Growth Model?” Accessed January 7, 2021.

Morningstar. “Stocks 400 – What Is Fair Value?”

Source: https://www.thebalancemoney.com/what-is-fair-value-5094687