FAIR VALUE ACCOUNTING: Definition & Benefits of Fair Value Accounting

fair value accounting

Fair Value

Fair value is a word with diverse definitions in the commercial world. It refers to an actual selling price of an asset that is agreed upon by a ready buyer and seller. This article, promises to help you understand fair value stocks, accounting, formula, and calculation. 

What is Fair Value?

Fair value refers to the exact worth of an asset in form of a product, stock, or security. Whereby there’s an agreement between the seller and the buyer on the exact value of the asset or product. This, therefore, is considered an amount or value that is fair to the buyer without putting the seller at a loss. This can also apply to a product that is sold in the market under normal conditions and not to one that is being liquidated.

In the financial sector, the term “fair value” has numerous meanings. In investment, it refers to the price at which a willing buyer and seller agree to sell an asset, providing that both parties are knowledgeable and eager to engage in the deal. Securities, for example, have a fair value that is determined by the market in which they are traded. FV is a term used in accounting to describe the estimated worth of various assets and liabilities that must be recorded on a company’s books.

Fair Value of Stocks

Fair value is the sale price agreed upon by a willing buyer and seller. Hence, making the FV of a stock a determinant by the market where the stock is traded. Fair value also represents the value of a company’s assets and liabilities when a subsidiary company’s financial statements are consolidated with a parent company.

When do we say a ‘stock is overvalued or undervalued 

This is simply when an investor puts a value on stocks and considers it with the current price. For example, if a stock is trading at $30 and you as an investor feel that the real value for the stock is $20, you can then say that the stock is overvalued and may wish to sell the stock if currently at hand.

Moreover, On the fair trade stock exchange, millions of stocks trade every day, and the price of these stocks is dependent on numerous factors such as demand and supply dynamics, the popularity of a stock, market impulse, and value of a stock facing current market price.

Hence, an investor needs to determine a stock’s fair value before they decide to buy it. Which is however not an easy task. As you will be needing an equity analyst to calculate what they think is the long-term intrinsic value of a stock, helping you see beyond the present market price.

Fair Value in Accounting

Fair value accounting is also one of the most commonly used financial accounting methods. It calculates the actual or estimated value of an asset. Which includes a few fair value accounting benefits listed below;

#1. It helps businesses survive: Fair value accounting helps businesses endure through financial difficulty. During these times it allows asset reduction. In other words, the value of an asset that is included in a sale can be declared an overestimated value. 

#2. Measurement of true income: fair value accounting is a total asset value that reflects the actual income of a company. It doesn’t bank on a report of profits and losses but instead just looks at actual value.

#3. Accuracy of valuation: With fair value accounting, valuations are more accurate, such that the valuations can follow when prices go up or down.

#4. Flexible to different types of assets: This sort of accounting is able to make valuations across all kinds of assets. Which is preferably better than using historical cost value which can change over time.

Fair Value Formula

Fair value can show the difference between the futures price and the cost to own all stocks index. We’ll be looking at two fair value formulas;

For example, the following formula is used to calculate a fair value for stock index futures:

Fair Value=Cash×{1+r(x/360)}−Dividends

where:

Cash=Current  Cash Value

r=Current interest rate paid to a broker to buy all 

stocks in the 500 index

x=Days to the expiration of the futures contract

Dividends=Amount of dividends until the contract

expiration. 

​While the formula to calculate the P/E ratio is 

the current stock price per share / current earnings per share

For instance, if you want to find the fair value for a utility, you have to compare the P/E ratio to other P/E ratios in the same industry.

If the company has a high P/E ratio it usually means the company is overvalued. On the other hand, a low P/E ratio shows the company is undervalued. For example, if you hold a stake of shares in a company with a P/E ratio of 4 and the average P/E ratio for other companies in the same industry is 2, you can be sure that your stock is expensive or, in other words, overvalued.

The next thing to do is to modify the stock price to the average P/E ratio. Let’s say the average P/E ratio is 2, and the P/E ratio on your stock is 4. This means the current price is $8 and earnings per share are $2. We know that by following the P/E ratio formula.

Fair Value Calculation

To understand the fair value calculation you just need to follow these steps:

Step 1

Calculate the P/E ratio.

P/E ratio formular = “current stock price per share” / ” current earnings per share.”

Step 2

Compare the P/E ratio for your company with other companies in the same industry. For instance, if you want to find the fair value for a bank, you must compare the P/E ratio to other P/E ratios in the banking industry.

Step 3

Interpret the meaning of the P/E ratio. A high P/E ratio means the company is overvalued and a low P/E ratio means the company is undervalued. For instance, if I own a company with a P/E ratio of 5 when the average P/E ratio for companies in the same industry is 3, I know that my stock is overvalued (expensive).

Step 4

Adjust the stock price down to the average P/E ratio for the industry. If the average P/E ratio is 3, and the P/E ratio on my stock is 5 then I can use the P/E equation to find what the stock price would need to be in order to have a P/E ratio of 3.

The equation is New P/E ratio x Earnings per share.

The answer is 3 x 2 = 6. The fair market value for this stock is 6.

In Conclusion,

There are many assumptions made when estimating a company’s fair value and a large number of inputs go into the calculation. Although every effort is made to ensure the assumptions are reflective of the company’s future prospects, it is impossible to predict the future with complete accuracy. 

Investors should therefore simply consider the estimated fair value as one of many considerations that go into making an investment decision. They still need to take their own investment objectives and risk appetite into consideration. Our aim is to empower you with information that can allow you to make informed decisions on your investments.

FAQs

What is fair value with example?

The true value of an item — a product, a stock – is referred to as its fair value. It is decided in order to arrive at an amount or value that is fair to the buyer while not putting the seller at a disadvantage. Company A, for example, sells its stock to Company B for $30 per share.

Why fair value is important?

Fair value is an important criteria for determining asset prices since it provides for a more accurate estimate of worth even when no recent sales are available to reference. The more accurate the financial appraisal of the asset, the better informed any asset-related decisions will be.

How do you determine the fair value of a stock?

The price-to-earnings (P/E) ratio is the most frequent method for determining a stock’s worth. The P/E ratio is calculated by dividing the company’s stock price by its most recent reported earnings per share (EPS). A low P/E ratio indicates that an investor purchasing the stock is getting a good deal.

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