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
Under fair value accounting, an asset is recorded at the price it could fetch in a transaction between informed and willing parties. This differs from the traditional method, where you deduct depreciation from the original cost to determine its book value.
For example, suppose ABC Limited purchased a vehicle for ₹10 lakh one year ago. With a 20% depreciation rate, the conventional accounting value would be ₹8 lakh. However, if the vehicle can currently be sold for only ₹7.5 lakh, you must record ₹7.5 lakh as its fair value in the 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
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Fair value
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Market value
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Representation
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Represents the true intrinsic value of an asset
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Represents the price at which an asset can be immediately bought or sold on the market
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Valuation
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Dictated by the fundamentals of the asset
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Dictated by the forces of demand and supply
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Frequency of change
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Does not change frequently
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Changes frequently based on the forces of demand and supply
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Accuracy
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Highly accurate
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Not very accurate
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Application
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Widely used in accounting and investing
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Only used in investing
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Fair value vs carrying value
Fair value and carrying value are two different approaches used to measure an asset’s worth in accounting.
Fair value refers to the estimated amount at which an asset could be exchanged in a current transaction between informed and willing parties. It takes into account market conditions, expected profitability, growth prospects, and associated risks.
Carrying value, or book value, is the figure recorded on a company’s balance sheet. You calculate it by deducting accumulated depreciation and any impairment losses from the asset’s original purchase cost.
Note: Carrying value is based on historical cost and accounting adjustments, not on the asset’s present market price.
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.
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