What Is Fair Value In Stocks English

What Is Fair Value Of Stocks?

Fair value of stocks refers to an estimated, rational, and unbiased price at which a share can be bought or sold, considering all factors like company fundamentals, market conditions, and economic indicators. It’s an assessment of what a stock is genuinely worth, beyond temporary market fluctuations.

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Fair Value Of Shares Meaning

The fair value of shares is a calculated estimate of a stock’s true worth, considering factors like the company’s financial health, market trends, and economic conditions. It represents an ideal price for the stock, distinct from its current market price, which can be influenced by speculative forces.

Fair value of shares is an analytical estimation of a stock’s intrinsic value. It incorporates company earnings, growth prospects, assets, and liabilities. Unlike market price, it’s less influenced by short-term market sentiments and more by fundamental financial analysis.

This value helps investors assess whether a stock is overvalued or undervalued in the market. It serves as a benchmark for making informed investment decisions, aiming for long-term value rather than short-term market fluctuations. Investors use it to gauge potential investment opportunities.

For example, after analyzing a company’s financials, an investor determines the fair value of its stock to be ₹500 per share. However, in the market, due to recent speculative trends, the stock is trading at ₹550. The stock is therefore considered overvalued compared to its fair value. In the same way if the stock is trading at ₹450 then it is considered as undervalued. 

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Example of Value

Suppose a company’s stock is trading at ₹200 in the market. After evaluating its financial performance, growth potential, and industry position, an investor calculates its fair value to be ₹250. This suggests the stock is undervalued in the market, offering a potentially profitable investment opportunity.

How To Calculate Fair Value Of A Stock? – Fair Value Formula

To calculate a stock’s fair value, you can use the Discounted Cash Flow method, which involves estimating how much money the company will make in the future and then determining what that future money is worth today. Another method is comparing the stock’s price with its earnings.

Fair Value Formula = Cash [1 + r (x/360)] – Dividends

  • “Cash” indicates the current value of the security in question.
  • The term “r” stands for the prevailing interest rate set by the broker.
  • “x” represents the number of days left until the futures contract reaches maturity.
  • “Dividends” point to the expected dividends to be received by the investor prior to the contract’s expiration date.

Let’s use the formula “Fair Value = Cash [1 + r (x/360)] – Dividends” with an example:

  • Assume the current value of a security (Cash) is ₹1,000.
  • The interest rate (r) set by the broker is 5% (or 0.05 as a decimal).
  • The number of days (x) until the futures contract expires is 90 days.
  • The investor expects to receive dividends of ₹30 before the contract expires.

Fair Value=1000[1+0.05(90/360)]−30

Using the given values, the fair value of the security, calculated with the formula, is ₹982.50. ​

Advantages of Fair Value

The main advantage of fair value accounting is that it provides a more accurate and current valuation of a company’s assets and liabilities. This reflects the true financial situation, aiding investors and stakeholders in making better-informed decisions based on current market conditions.

  • Real-time Valuation: Fair value offers a current market-based valuation of assets and liabilities, providing an up-to-date financial picture.
  • Transparency: It enhances transparency in financial reporting, giving a clearer view of a company’s worth.
  • Investor Confidence: Accurate valuations build investor trust and confidence in financial statements.
  • Market Trends Reflection: Fair value reflects current market trends and conditions, offering insights into the actual market performance of assets.
  • Risk Management: It helps in better risk assessment and management by showing the real value of assets and liabilities.

Fair Value Vs Market Value

The main difference between fair value and market value is that fair value is an estimated price considering all aspects of the asset, including utility and earnings potential, while market value is the price at which an asset is currently traded in the market.

CriteriaFair ValueMarket Value
DefinitionEstimated price considering utility, earnings potential, and broader economic conditions.Current price at which an asset or security is traded in the market.
DeterminationBased on calculations, models, and intrinsic value assessments.Dictated by supply and demand in the open market.
PurposeUsed in financial reporting, to assess an asset’s value for accounting.Reflects what buyers are willing to pay and sellers willing to accept in the market.
VolatilityLess influenced by short-term market fluctuations.More susceptible to short-term market trends and sentiments.
ApplicationMore common in accounting and financial analysis.Commonly used in trading and investment decisions.
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What Is Fair value of Stocks? –  Quick Summary

  • Fair value of shares is an assessed valuation reflecting a stock’s actual value based on the company’s fundamentals, economic indicators, and market conditions, representing its ideal price, unlike the market price swayed by market speculation.
  • Fair value of a stock can be calculated using the Discounted Cash Flow approach, projecting future earnings and discounting them to present value, or by comparing the stock’s current price with its earnings per share.
  • Fair value accounting’s main benefit lies in offering a precise, up-to-date assessment of a company’s assets and liabilities, accurately depicting its financial health and assisting investors and stakeholders in making informed decisions aligned with the latest market trends.
  • The key distinction is that fair value is a calculated estimation based on the asset’s overall utility and potential earnings, while market value represents the asset’s current trading price in the market.

Fair Value Of Shares Meaning – FAQs  

What Is Fair value of Stocks?

Fair value of stocks is a calculated estimate of their true worth, considering factors like company performance, financial health, and market conditions. It represents what a stock should be valued at, distinct from its market price.

How do you calculate fair value?

Fair value is calculated using methods like the Discounted Cash Flow (DCF), where future earnings are projected and discounted to present value, or by comparing a stock’s Price-to-Earnings (P/E) ratio with similar companies.

What are the types of fair value?

Fair value types primarily include Level 1, using observable market data like stock prices; Level 2, involving less observable market data; and Level 3, based on unobservable inputs and companies’ own assumptions in valuations.

Why is fair value used?

Fair value is used for more accurate financial reporting. It reflects an asset’s or liability’s true value, offers clear understanding of a company’s financial health, and aids in making informed investment and business decisions.

What is the difference between fair value and current cost?

The main difference between fair value and current cost is that fair value assesses an asset’s market value based on demand and supply, while current cost focuses on the expense of replacing the asset today.

What is a good fair value ratio?

A good fair value ratio depends on the industry and market conditions. Generally, a ratio close to or less than 1 suggests a potentially undervalued stock, while significantly higher ratios might indicate overvaluation. However, this varies with sector norms and economic factors.

What is the difference between fair value and stock price?

The main difference between fair value and stock price is that fair value is an estimated intrinsic value of a stock, considering fundamentals, while stock price is the actual trading price in the market, influenced by supply and demand.

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