Fair Value

Fair value is the estimated worth of an asset based on current market conditions and available information. Investors compare fair value with the market price to understand whether a security may be undervalued or overvalued, while companies use it to value assets and liabilities in their financial statements.

Key points include:

• Fair value reflects the price agreed upon by willing buyers and sellers in an orderly transaction.
• Investors often estimate fair value using fundamental analysis and valuation models such as Discounted Cash Flow (DCF).
• Companies may use fair value accounting instead of historical cost for selected assets and liabilities.
• For example, a stock has a fair value of ₹1,480 but trades at ₹1,200, while a vehicle purchased for ₹10 lakh has a fair value of ₹7.5 lakh based on its current selling price.

Fair value is the estimated price at which an asset can be exchanged or a liability settled between knowledgeable, willing parties in an orderly market transaction. Unlike a forced sale price, it reflects the asset's value under normal market conditions.

The concept is widely used for assets traded in active markets, including securities. It also helps investors, lenders, and businesses evaluate assets using consistent and transparent valuation methods.

Investors use fair value to estimate whether a stock is trading above or below its intrinsic value. This estimate is generally based on fundamental analysis, which considers a company's financial performance, growth prospects, and other relevant factors.

• If the fair value is higher than the current market price, the stock may be considered undervalued.
• If the fair value is lower than the market price, the stock may be considered overvalued.

These assessments are only one part of investment analysis and should not be treated as a recommendation.

Example

Assume the fair value of ABC Limited is estimated at ₹1,480 per share, while its current market price is ₹1,200.

An investor may conclude that the stock appears undervalued based on this estimate. If the share price later rises to ₹1,800, it trades above the estimated fair value. In this example, the difference between ₹1,800 and ₹1,480 is ₹320 per share.

Fair value accounting records certain assets and liabilities at the amount they could be exchanged for in an orderly transaction between willing parties. This differs from the historical cost method, which generally records assets after adjusting for depreciation or impairment.

Example of fair value accounting

Suppose a company purchases a vehicle for ₹10 lakh. Under the historical cost method, assuming 20% annual depreciation, the vehicle's value after one year would be ₹8 lakh.

If the vehicle's current selling price is ₹7.5 lakh, fair value accounting records it at ₹7.5 lakh, reflecting its estimated market value rather than its depreciated purchase cost.

One commonly used approach to estimate fair value is the Discounted Cash Flow (DCF) method. It calculates the present value of a company's expected future cash flows and adds the discounted terminal value to estimate the business's overall value.

Step 1: Calculate the present value of future cash flows

The present value (PV) is calculated using the following formula:

PV = Σ [CFₜ ÷ (1 + r)ᵗ]

Where:

Step 2: Calculate the terminal value

Terminal value estimates the value of all future cash flows beyond the forecast period, which is generally 3–5 years.

Terminal Value = CFₜ × (1 + Terminal Growth Rate) ÷ (Discount Rate − Terminal Growth Rate)

After calculating the terminal value, discount it to its present value using the DCF formula.

Step 3: Estimate enterprise and equity value

Add the present value of projected cash flows and the discounted terminal value to determine the enterprise value. To estimate the equity value, subtract the company's total debt from the enterprise value.

Fair value accounting helps businesses present financial information that reflects current market conditions.

Read more: CRAR ratio

The fair value of an asset can change based on several business and market-related factors. Revenue, economic conditions, and the level of risk associated with an asset can influence its estimated worth. 

Fair value and carrying value are both used to measure an asset's value, but they are calculated differently. Fair value considers current market conditions, while carrying value is based on the asset's original cost after adjusting for depreciation and impairment.

Example of carrying value

Suppose Company A purchases a backhoe for ₹22,50,000 with a useful life of 10 years and annual depreciation of ₹1,50,000.

Its carrying value after 10 years is:

Carrying Value = ₹22,50,000 − (₹1,50,000 × 10) = ₹7,50,000

Fair value is an important valuation method used in both investing and accounting. It helps estimate the current worth of assets and liabilities based on market conditions rather than historical cost alone. While fair value can support better financial analysis and reporting, investment decisions should also consider individual financial goals, risk tolerance, and thorough research. Past performance does not guarantee future results, and all investments are subject to market risks.