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Fair Value: Definition, Formula & Example

Nupur Wankhede

Fair value is a widely used concept in finance and accounting. It helps investors, analysts, and businesses assess the true worth of an asset based on objective methods rather than short-term market fluctuations. In stock markets, understanding fair value is essential for evaluating whether a security is overpriced, underpriced, or reasonably valued.

What is Fair Value

Fair value refers to the estimated worth of an asset, liability, or company based on current market conditions and available information. It reflects the price at which a willing buyer and a willing seller would agree to transact in an orderly market. Unlike market price, which can be driven by short-term demand and supply forces, fair value seeks to present a more intrinsic and unbiased assessment.

Fair Value vs Fair Market Value

A side-by-side look at fair value and fair market value shows how theoretical valuation differs from actual market pricing.

Aspect Fair Value Fair Market Value

Definition

The theoretical price of an asset based on valuation models

The price at which an asset is actually traded in an open market

Use Case

Accounting, financial reporting, investment analysis

Real-world transactions, taxation, and legal matters

Dependence

Derived from models and assumptions

Determined by prevailing market conditions

Subjectivity

Can vary depending on the valuation method used

Reflects actual buyer–seller agreement

Example

Calculated intrinsic value of a company’s share

The price at which shares are currently traded

Fair Value of Shares Explained

In stock markets, the fair value of shares represents the intrinsic worth of a company’s equity. Analysts calculate it by considering financial statements, earnings, assets, liabilities, and growth potential. The fair value is then compared to the current market price to identify whether a stock is undervalued or overvalued.

Fair Value Formula

A commonly used formula for calculating fair value is:

  • Fair Value of Share = (Sum of Present Value of Expected Future Cash Flows) ÷ Number of Outstanding Shares

Key inputs include:

  • Expected cash flows (such as earnings or dividends)

  • Discount rate (reflecting risk and time value of money)

  • Outstanding shares (total shares issued by the company)

Example of Fair Value Calculation

Suppose a company is expected to generate annual cash flows of ₹2 Crores for the next 5 years. Using a discount rate of 10%, the present value of these cash flows equals ₹7.6 Crores. If the company has 1 Crore outstanding shares, the fair value per share will be:

₹7.6 Crores ÷ 1 Crore = ₹7.6 per share

If the stock is trading at ₹6, it may be considered undervalued relative to its fair value.

Importance of Fair Value

Fair value plays a significant role in finance and investing because it:

  • Provides a benchmark for evaluating stock prices

  • Assists companies in reporting assets and liabilities accurately

  • Enhances transparency in financial statements

  • Helps investors make informed comparisons between companies

  • Supports regulatory compliance and audit processes

Fair Value in Price Discovery

Fair value contributes significantly to the price discovery mechanism in markets. While fair value is theoretical, price discovery is practical, reflecting ongoing trades. The interaction between both concepts ensures that market prices eventually converge toward intrinsic values over time.

Fair Value vs Market Price

Here’s a quick comparison of fair value and market price:

Aspect Fair Value Market Price

Basis

Derived from valuation models

Driven by demand and supply

Volatility

Relatively stable

Can fluctuate daily or even hourly

Objective

Represents intrinsic worth

Represents actual traded price

Investor Use

Used for long-term decision-making

Used for executing buy/sell trades

Example

Valuation suggests ₹100 per share

Stock trading at ₹95 in the market

How to Calculate Fair Value of Shares

Methods for calculating fair value include:

  • Discounted Cash Flow (DCF): Projects future cash flows and discounts them to present value.

  • Price-to-Earnings (P/E) ratio model: Uses industry average P/E multiples to estimate intrinsic value.

  • Dividend Discount Model (DDM): Based on present value of expected future dividends.

  • Asset-based valuation: Considers net asset value after adjusting for liabilities.

  • Online calculators: Financial portals and tools provide quick fair value estimations.

Limitations of Fair Value

Fair value, while useful, has limitations:

  • Subjective assumptions: Results vary depending on inputs like discount rate or growth forecasts.

  • Market inefficiencies: Prices may deviate significantly from calculated fair value.

  • External shocks: Events like geopolitical crises or regulatory changes can distort valuations.

  • Data accuracy: Requires reliable financial data, which may not always be available.

Conclusion

Fair value offers an intrinsic measure of worth that helps investors and businesses make sound financial decisions. By comparing fair value with market price, one can assess whether a stock is undervalued, fairly priced, or overvalued. However, it must be applied with caution, considering assumptions, limitations, and broader market conditions.

Disclaimer

This valuation method should not be considered for taking any investment decisions. This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.

FAQs

What is the difference between fair value and market value?

Fair value is the theoretical worth of an asset based on valuation models, while market value is the actual price determined by demand and supply.

Why is fair value important in the stock market?

Fair value helps investors assess whether a stock is undervalued or overvalued, supporting informed investment analysis.

What factors affect the fair value of a stock?

Earnings, assets, liabilities, growth potential, interest rates, and market risks all impact a stock’s fair value.

What is the role of fair value in price discovery?

Fair value provides a benchmark against which market forces operate, ensuring that prices gradually reflect intrinsic worth.

Hi! I’m Nupur Wankhede
BSE Insitute Alumni

With a Postgraduate degree in Global Financial Markets from the Bombay Stock Exchange Institute, Nupur has over 8 years of experience in the financial markets, specializing in investments, stock market operations, and project management. She has contributed to process improvements, cross-functional initiatives & content development across investment products. She bridges investment strategy with execution, blending content insight, operational efficiency, and collaborative execution to deliver impactful outcomes.

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