Fair Value

Fair value is a term with several meanings in the financial world. In investing, it refers to an asset's sale price agreed upon by a willing buyer and seller, assuming both parties are knowledgeable and enter the transaction freely. For example, securities have a fair value that's determined by a market where they are traded. In accounting, fair value represents the estimated worth of various assets and liabilities that must be listed on a company's books.

In its broadest economic sense, fair value represents the potential price, or the value assigned to a good or service, taking into account its utility, supply and demand, and the amount of competition for it. Although it infers an open marketplace, it is not quite the same as market value, which simply refers to the price of an asset in the marketplace (not intrinsic worth).

In the investment world, a common way to determine a security's or asset's fair value is to list it in a publicly-traded marketplace, like a stock exchange. If shares of company XYZ trade on an exchange, market makers provide a bid and ask price for those shares on a daily basis. An investor can sell the stock at the bid price to the market maker and buy the stock from the market maker at the ask price. Since investor demand for the stock largely determines the bid and ask prices, the exchange is a reliable method to determine a stock’s fair value. 

The fair value of a derivative is determined, in part, by the value of an underlying asset. If you buy a 50 call option on XYZ stock, you are buying the right to purchase 100 shares of XYZ stock at $50 per share for a specific period of time. If XYZ stock’s market price increases, the value of the option on the stock also increases.

In the futures market, fair value is the equilibrium price for a futures contract—that is, the point where the supply of goods matches demand. This is equal to the spot price after taking into account compounded interest (and dividends lost because the investor owns the futures contract rather than the physical stocks) over a certain period of time.

The International Accounting Standards Board defines fair value as the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on a certain date, typically for use on financial statements over time. The fair value of all a company's assets and liabilities must be listed on the books in a mark-to-market valuation. The original cost is used to value assets in most cases.

In some cases, it may be difficult to determine a fair value for an asset if there is not an active market for it. This is often an issue when accountants perform a company valuation. Say, for example, an accountant cannot determine a fair value for an unusual piece of equipment. The accountant may use the discounted cash flows generated by the asset to determine a fair value. In this case, the accountant uses the cash outflow to purchase the equipment and the cash inflows generated by using the equipment over its useful life. The value of the discounted cash flows is the fair value of the asset.

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