What is fair value? All of us whether business people or not, we get to a point that we decide to dispose of items, asset, stock, and even a company. But determining the value and how to arrive at the fair value of these valuables can be a difficult task.
Understanding Fair Value
Fair Value can be defined as the price or value of an item. Specifically, it`s the amount that the item could be sold for that is fair for both the buyer and the seller. The fair value does not relate to products being sold in liquidation; instead, it refers to products that are being sold under normal, reasonable conditions.
The concept of fair value accounting system was driven by the Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC) in an effort to provide greater disclosure, transparency and consistency in financial statements.
The aim was to improve the quality, consistency and comparability of financial reporting to provide superior and thorough information to the investment community. Accounting Standards Codification 820, (Fair Value Measurements), formerly known as Statement of Financial Accounting Standards (SFAS) No. 157, ASC 820, give a uniform definition for fair value and put an emphasis on the use of market inputs when valuing an asset or liability.
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This is also in other words known as “mark-to-market” accounting since financial statements are now required to clearly state upon which of the three-level hierarchy inputs the reported values are based on.
Fair value becomes more important when assets are sold or a company is acquired. Using fair value gives room for fair and appropriate sales price to be determined for individual items or an entire business. When a company is acquired, the fair value helps determine the value of the assets and arrive at a reasonable sales price for the business.
Fair value is also essential when valuing assets on financial statements. If a product decreased in value, it may affect the depreciation costs of the business and lower the value of the assets. But if a product increases in value, it will cause the value of the asset and company to increase. Fair value is also applicable to the value of a stock or security in the open market.
Examples of fair value
Company A sells its stocks to company B at $40 per share. Company B thinks he could sell it at $50 per share once he acquires it and so decides to buy a million shares at the original price. It`s considered fair value because the price was agreed by both sides and they both benefit from the sale.
Why fair value matters: The question of what security is really worth is one of the fundamental subjects in investing. By calculating fair value, investors can answer this question in some form, although it may not be precise. However, fair value estimates are key to any investor’s repertoire.
Approaches to fair value can differentiate value investors from growth investors. Although growth investors aggressively depend on earnings estimates that could either be right or wrong, too high, or otherwise unreliable, unlike value investors, they only buy stock selling at a discount to their fair value, and then wait for the fair value of their investments to be realized.
Despite both types of investors face the prospect that their companies may falter, mature, or get so big that maintaining historical growth rates is impossible, most of them buy stocks expecting that stock price will rise to match the fair value of the company.
Example of how fair value works
Let’s assume Company XYY stock currently sells for $20 per share. Company XYY just introduced a new product line, rebrands its packaging, and hired some new managers away from a competitor. Although these changes do not directly reflect on the company’s financial statements, they may improve Company XYY’s competitive advantage in key markets.
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Because of that, investors may assume a stock’s future cash flows will be much higher going forward. They may take their estimated growth rate and calculate the fair value of the stock at $40 per share, or $30 more than what it is currently selling for.
There`s no one fair value for a stock at any given time; they vary depending on an investor. It`s established that an investor’s required margin of security, which is a percentage equal to the amount a stock’s price is below its fair value, determines what stock price will attract that investor.
In the example above, if the investor’s required margin of safety is 40%, the investor would only consider purchasing the stock if it traded at $20 or less.
Measuring fair value
There are basically two common ways to measure fair value and they are market value and cost method.
The market approach is a simple way to measure the fair value of a product if it is readily available for sale. For example, if you have a car that you want to sell, there are likely other similar cars available for sale.
Determining the disposable price of the car is easy because there are many other cars of the same make and model for sale. Fair value can be determined by referring to the price of similar cars.
The cost method is a popular method for determining the fair value of a product by how much it would cost to replace the item. Cost is usually used for items that hold their value and have little depreciation. Insurance companies usually use cost as a fair value when covering the loss of an item.
For instance, if your home burns down, the insurance company may use the cost method to determine the fair value of your home. What will be the cost to replace your house? Using the cost method, a value can be easily determined for an item based on what it will cost to build or re-purchase that item.