What Is 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.
KEY TAKEAWAYS
In investing, fair value is a reference to the asset's price, as determined by a willing seller and buyer, and often established in the marketplace.
Fair value is a broad measure of an asset's worth and is not the same as market value, which refers to the price of an asset in the marketplace.
In accounting, fair value is a reference to the estimated worth of a company's assets and liabilities that are listed on a company's financial statement.
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Fair Value
Understanding Fair Value
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 implies 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.