Fair Value in Stocks – Definition, Advantages, and Examples

Summary 

This article discusses the concept of fair value in stock price valuations and provides examples. It also delves into the salient differences between fair value and market price. Lastly, the article mentions some of the benefits of employing fair value measurements in valuing securities.   

Fair value refers to the sale price of a stock arrived at through mutual consent by a willing buyer and a willing seller. The fair value of a stock is determined through a process of price discovery in free markets. Stock prices are determined by the markets in which the stocks are traded. As securities trade on a public platform, the demand for these securities creates their bid and ask prices. The same then helps arrive at a consensual market price which can provide a preliminary measure of fair value. For example, HDFC Bank stock’s bid price on September 21, 2023, was INR1,560.50, while its ask price was INR1,561.70.   

As an investor, you may also use variables like recent market transaction data, a company’s growth prospects, and expected future earnings from the stock to determine the stock’s fair value. Hence, fair value doesn’t always equate to market value. 

Fair value versus market value

Fair value measures the value of the stock to the investor, while market price refers to the price of the stock on the stock exchange where it is traded. Thus, fair value is the intrinsic value of the stock and changes slowly depending on the stock’s fundamentals. Market value, however, is prone to greater fluctuations based on the market’s assessment of both short-term and long-term factors that influence the security’s market price. 

For example, HDFC Bank stock’s 52-week price range was INR1,365.05-INR1,733.95. We can see that the security has traded over a wide price range over the past year. Similarly, the market price for most securities does not stay constant but tends to fluctuate because of several factors including macroeconomic data and geopolitics, besides the business fundamentals directly affecting the company.      

An investor may compare a stock’s market price to the fair value estimate determined by him or her. For example, if the fair value exceeds the prevailing market price of the stock, it gives the investor an indication to buy the stock. Should the stock’s fair value be lower than its market price, it provides a sell signal for the investor. Hence, fair value represents the price at which a stock’s desired investment characteristics are met, like growth and rate of return. 

For example, if a stock is currently trading at INR500, and an investor estimates its fair value at INR600, this may prompt the investor to purchase the stock, as he or she believes that the market is undervaluing the stock. On the other hand, if the fair value of the same security is estimated at INR400, the investor may conclude that the stock is overvalued at the prevailing market price. He or she may then want to sell the security.  

How to calculate fair value

Fair value for a Security can be computed using multiple approaches. Some of these include:

• Market approach: This method uses the market prices of similar securities to arrive at a fair value for the stock. For example, the stock price and valuation metrics for competitors like ICICI Bank, Axis Bank, and Kotak Mahindra Bank may be considered, in arriving at a fair value for HDFC Bank stock. 
• Income approach: This method uses the expected cash flows from the stock, combined with variables including required rate of return, stock beta, growth rates for the company, and risk-free rate of return to arrive at the present value fair value for the stock. For example, HDFC Bank’s fair value may be computed using the Capital Asset Pricing Model (CAPM) and discounted cash flow analysis. These valuation models use variables including beta, risk-free rate, leverage, cost of debt, and market rate of return to arrive at a fair value estimate for the bank’s stock.  

Advantages of fair value

Fair value is a measure of the estimated or real value of a security. Gauging a stock’s fair value provides several benefits to investors. These include:

• Accuracy: Fair value measures are often more accurate than market prices as they price in all the data specific to an investor’s risk and return objectives. Besides, prices arising out of market equilibrium may not always reflect all the available information.    
• Adaptability: Numerous assets and liabilities can be valued using fair value measures. These also provide investors with a common yardstick when comparing investments.   
• Dynamic return measurement: Unlike historical valuations which are static in nature, fair value measurement is dynamic and can change depending on the investment’s fundamentals. 

 In conclusion

Understanding and estimating the fair value for a security helps investors make financial choices which are suitable to their risk and return profiles. As an investor, you must learn the basics of fair value to understand how it can be arrived at. If you are still unclear about the basics, consulting with an experienced financial advisor would be the best way to get started on your trading journey.