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Fair Value

The actual value of a product, stock, or security that is agreed upon by both the seller and the buyer

What is Fair Value?

Fair value refers to the actual value of a product, stock, or security that is agreed upon by both the seller and the buyer. Fair value is applicable to a product that is sold or traded in the market where it belongs or in normal conditions and not to one that is being liquidated. It is determined in order to come up with an amount or value that is fair to the buyer without putting the seller on the losing end.

 

Fair Value

 

For example, Company A sells its stocks to company B at $30 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 is considered fair value because the price was agreed by both sides and they both benefit from the sale.

 

Fair Value vs. Carrying Value

Fair value and carrying value are two different things. Consider the following:

  • Fair value is the actual selling value of an asset that is agreed to be paid by the buyer as set by the seller. Both parties benefit from the sale and that calculating it involves analyzing profit margins, future growth rates, and risk factors.
  • Carrying value is also called book value, which refers to the amount or value of an asset as what appears on the balance sheet.
  • It is determined by deducting the accumulated depreciation of the asset, as well as the impairment expenses, from the original price as indicated in the balance sheet.
  • Carrying value reflects not the original purchasing price of the asset but its actual value after a number of years.

 

To illustrate the fact, let’s say Company A, a construction company, bought a backhoe for its operations at $30,000. Assuming it will last for 10 years with a depreciation expense of $2,000 for each year, then, its carrying value would already be $10,000.

Carrying Value = $30,000 – ($2,000 x 10) = $10,0000 

 

To learn more, check out CFI’s Business Valuation Modeling course.

 

Fair Value vs. Market Value

Market value is also different from fair value in the following points:

  • Market value fluctuates, unlike fair value.
  • It may be based on the most recent pricing or quotation of an asset. For example, if during the last three months, the value of a share in Company A was $30 and during the most recent evaluation, it went down to $20, then its market value is $20.
  • Market value is dependent on supply and demand in the market where it operates. For example, a house that is to be sold will see its price determined by existing market conditions.

If the owner sells the property for $200,000 during a low time in the real estate market, it might not get sold still because the demand is low. But if it is sold even for $1 million during a high time, it will get sold if there is anyone who can afford it.

 

Figure 1. Overview of Financial Valuation Techniques (from CFI’s Business Valuation Course)

 

Advantages of Fair Value Accounting

Fair value accounting measures the actual or estimated value of an asset. It is one of the most commonly used financial accounting methods because of its advantages, which include:

 

1. Accuracy of valuation

With fair value accounting, valuations are more accurate such that the valuations can follow when prices go up or down.

 

2. True measure of income

With fair value accounting, it is the asset value that reflects the actual income of a company. It doesn’t rely on a report of profits and losses but instead just looks at actual value.

 

3. Most used by many

Such a method is able to make valuations across all types of assets, which is better than using historical cost value which may change through time.

 

4. Helps businesses survive

Fair value accounting helps businesses survive during a financially difficult time because it allows asset reduction (or the act of declaring that the value of an asset that is included in a sale was overestimated).

 

To learn more, check out CFI’s Business Valuation Modeling course.

 

More Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Enterprise Value vs. Equity Value
  • Forced Sale Value
  • Goodwill
  • Methods of Depreciation

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