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Fair Value Vs Market Value - Meaning, Key Differences and Examples

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What is Fair Value? 

The anticipated price at which an asset would trade in an open market, between a willing buyer and seller, is termed fair value. Basically, it represents the actual value of the asset and is entirely based on the current market conditions. This makes it a significant concept in the financial market; since it helps financial analysts and investors to determine if an asset is priced fairly. 

That being said, let's walk you through a thorough brief on what is fair value, why it is important, and how it compares to market value. Irrespective of what you are looking for (whether you are just an investor trying to make smarter decisions or are simply curious about fair value meaning), this guide will pretty much cover it all. Let's get started!

Understanding Fair Value in Detail  

Looked closely, fair value meaning involves a much deeper understanding of an asset's intrinsic value rather than merely the price it may bring in. It factors in the current market trends, the current supply and demand, and any prospective growth or decline in the future. 

Indian Accounting Standard 113 (Ind AS 113) defines fair value as the amount that would be received for selling an asset or paid to transfer a liability in a structured transaction between market participants on the measurement date.

This definition means fair value is based on what buyers and sellers in the market would agree on, not just on the company’s plans or intentions. Fair value calculation always uses current market data whenever possible. However, if such data is not available, other methods may be used to estimate the value.

 Additional Read: What is Trading Account: Definition, Types & Benefits

Importance of Fair Value in the Financial Market 

In financial markets, fair value plays a solid role by offering transparency and accurate asset pricing. It helps investors and analysts make informed decisions; especially in volatile markets where prices fluctuate frequently. 

To be more precise, fair value is an accurate representation of estimating the real worth of assets and what they would sell for under normal market conditions. 

In addition, as stated earlier, fair value determines an asset's worth by using the fundamentals. This fundamental analysis helps in assessing the equities’ intrinsic value in order to find out long term investment opportunities. This involves evaluating various economic factors and elements such as interest rates, GDP, employment rates, production, manufacturing, and company earnings. 

All in all, fair value calculation helps in preventing market manipulation and promotes more informed investment strategies. By offering a more accurate valuation, fair value calls for more ethical trading practices and helps investors in identifying and capitalising on market opportunities.

Methods to Determine Fair Value   

It might be difficult to calculate fair value when there isn't a clear market price in place. However, the following are the main methods to determine what is fair value: 

Note: Each method comes with its own set of strengths and applications, based on the availability of market data and the kind of asset.

  1. Discounted Cash Flow (DCF) Method

    This method determines the value of an asset by calculating the present/ current value of its projected future cash flows. It includes casting both inflows and outflows and then applying a discount rate to reduce them to their present value. This strategy works best with assets like stocks and bonds that yield a consistent income.

  2. Analysis of Comparative Markets

    This method is all about evaluating the asset against other similar assets on the market. You can determine the asset's fair value by comparing it with recently sold comparable items. This method is generally used for real estate and other tangible assets, where market comparisons are available.

  3. Cost Approach

    The cost approach evaluates value based on the expense of replacing or reproducing the asset, which accounts for depreciation. It is useful for assets like unique or specialised equipment that don’t have any direct market comparisons. 

  4. Income Approach

    This method determines an asset's worth by projecting its projected revenue. It involves capitalising future income into a present value; which is almost similar to DCF, but specifically emphasises income-producing assets.

Additional Read: Difference Between Demat and Trading Account

Fair Value vs. Market Value  

The fair value measures the intrinsic value of an asset. However, market value is estimated by different demand and supply forces. 

Moreover, market value generally keeps on fluctuating more than fair value. Fair value on the other hand, is less volatile and remains stable over time. 

Because both these terms might come up in the same discussion and concept, it becomes challenging to find out the major difference between the two. That being said, below is a brief tabular distinction of fair value vs market value. Take a look. 

Fair Value

Market Value

Fair value is derived fundamentally. Hence, the fair value calculation model is applied to the fundamental valuation of an asset or a firm as well. 

Market value is entirely dependent on market conditions. In no terms can it represent the value of an asset accurately. 

This is entirely based on true value and does not get influenced by demand and supply. This is yet another reason why it is applied in accounting purposes. 

This value gets decided after the buyer and the seller meets. Hence, the price is solely based on negotiation and not in terms of logic. Market value is commonly used for trading purposes. 

While estimating the fair value of an asset, certain changes are made for impairment. This helps in calculating the true value of an asset. 

Usually, market value is never the accurate way to calculate the true value of an asset. The sole reason is that it entirely relies on demand and supply which keeps on fluctuating constantly. 

Examples of Fair Value Calculation 

To get a better flair of how fair value is calculated, below is a list of a few common examples. Each of these examples are spread across a variety of asset classes to help you get a better idea. However, note that in order to determine an asset's fair value, each method takes certain market conditions and considerations into account.

  1. Stock Valuation

    To calculate the fair value of a stock, financial analysts analyse the company’s earnings, potential for future growth, and later, compare these factors with current market conditions. To determine a stock's fair value, methods like price-to-earnings (P/E) ratios and discounted cash flow (DCF) analysis are often used.

  2. Real Estate

    A property's fair value is determined by considering a number of variables, such as its location, existing market conditions, and the prices of similar properties that have been sold recently. Appraisers usually calculate the recent sales via comparative market analysis. This process guarantees that the property's value is in line with comparable sales prices and market conditions.

  3. Bond Pricing

    For bonds, fair value calculation is based on the bond’s coupon rate, current interest rates, and time to maturity. Using the current market interest rate, the face value of the bond at maturity and the present value of future coupon payments are discounted back to the present value. This also helps in concluding if a bond is trading at a premium or a discount relative to its fair value. 

Challenges and Limitations in Assessing Fair Value 

Because fair value often requires making speculative predictions about future cash flows and sometimes volatile market conditions, determining it can be subjective. Here are some major challenges that create uncertainty in fair value calculation.

  1. Competitive Advantage

    Businesses with a long-lasting edge over their competitors, (being a well-known brand, having innovative technology, or a dominant market position), typically hold higher fair values.

  2. Volatility and Risk

    When a stock has higher risk and volatility, investors may seek a higher return to compensate for the increased risk. This is because the volatility could potentially result in a lower fair value.

  3. Revenue and Earnings

    An important consideration while assessing a company's fair value is the rate at which its earnings and revenue are growing. Businesses that have robust and steady growth typically come with higher fair values.

  4. Market, Industry, and Economic Conditions 

    A stock's fair value can be influenced by the general state of the market and industry. Moreover, economic factors like inflation, unemployment, and interest rates, can have a massive impact on how much stocks are worth at fair value.

  5. Financial Health and Debt

    A company's fair value can be impacted by its debt levels and financial stability. High debt levels have the potential to lower fair value besides raising the risk.

  6. Regulatory Changes

    Certain changes to laws or government policies may have a huge effect on certain businesses and sectors. This can eventually end up affecting their fair values.

  7. Macroeconomic and Global Events

    Events that affect the entire world; like natural disasters, trade disputes, pandemics, or geopolitical conflicts, can also have a significant impact on stock valuations.

Conclusion  

Fair value is indeed a significant concept in the financial market that offers a more reliable and accurate representation of an asset’s worth. While it does have its own set of challenges, understanding fair value helps investors by ensuring more transparent pricing across financial markets. All in all, it is important to truly differentiate and know the ins and outs of fair value vs market value to grasp the real value of an asset. 

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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Frequently Asked Questions

What does fair value mean in financial terms?

Answer Field

In financial terms, fair value refers to the estimated worth of an asset based on both market conditions and intrinsic factors. It provides a clear picture of what an asset is truly valued at; unlike market value, where the price is solely determined by supply and demand in the market.

How is the fair value calculated?

Answer Field

Fair value calculation is done by several methods including discounted cash flow analysis, market comparisons, cost approach, and income approach. These methods determine the asset's actual value, which may differ from its market value. 

What is the difference between fair value vs market value?

Answer Field

The major fair value vs market value difference lies in how they are determined. Fair value is all about representing the intrinsic value of an asset by considering market conditions and potential future growth. On the other hand, market value is the price that an asset can bring at any given moment in an open market. 

Why is fair value important for investors and financial analysts?

Answer Field

Fair value is essential for financial analysts and investors because it helps them determine if an asset is overpriced or underpriced compared to its market value. This data is essential for making wise and informed decisions, particularly when it comes to volatile markets where trading accounts can change drastically, depending on the market sentiment.

What are some common challenges in assessing fair value?

Answer Field

One major challenge in assessing fair value is the amount of subjectivity involved. This is because different approaches can yield different results. Moreover, unlike the easy nature of market value in a trading account, fair value assessments are also affected by the unpredictability of market conditions. This makes it even more challenging to rely on a single, consistent metric.

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