Fair value definition

What is fair value?

Fair value is often used to describe the value attributed to a stock by an individual investor or broker. However, in futures trading, it can refer to the predicted price of a market, which is reflected in the cost to open a position.

What is the fair value framework?

The fair value framework is just a way to describe the principle that an asset has an inherent worth. It is the criteria that forms our understanding of an asset’s potential price, which is determined by the market.

Fair value and market value are often used interchangeably, but this is not necessarily the case. Fair value is the price that both the buyer and the seller agree upon. Because both are willing to pay the price, this becomes the actual selling value. Neither party in the transaction feels that they have lost out in some way, as both feel the asset was priced correctly.

Market value is the market capitalisation of the stock, which is based on supply and demand. It considers that people might pay more or less than the fair price, which is why it can give an indication of whether a company’s shares are over- or undervalued.

How is the fair value of an asset measured?

The fair value of an asset is measured by analysing the inherent value of the security. Individual traders and investors can decide on the fair value of an asset by doing a thorough analysis of the company’s information – often found on its balance sheet.

Example of calculating fair value

Many traders and investors calculate the fair value of an asset by measuring its price-to-earnings (P/E) ratio and earnings per share (EPS).

Let’s say you buy ABC shares at £100 per share. ABC has five million shares in circulation and turns a profit of £2 million. This means the earnings per share is 40p (£2 million/£5 million) and the P/E ratio equals 250 (100 / 0.40).

In order to assess the fair value, you decide to do the same analysis on a few other companies in the same industry and you find out that the average P/E ratio in the industry is 150. You can now see that ABC shares might be overvalued. If ABC’s P/E ratio was in line with the rest of the industry, the fair value of the stock would be £60 (150 x 0.40).