What is the Fair Value of Stocks? Meaning, Calculation, and Advantages

Fair value is the suitable or reasonable value of a stock. There are many distinct approaches to defining, computing, and evaluating the value of stocks. It is important to find the fair value of a stock to make the right investment decisions. It will help you to know if it is worth investing in a stock. That is why you must know the fair value. Let’s explore what the fair value of a stock is through this article.

Key Highlights:

• Fair value represents the true value of stocks based on fundamental analysis.

• A particular stock’s fair value helps investors decide whether it is undervalued or overvalued.

• Calculating the fair value gives you a transparent and accurate risk assessment of stocks.

Fair Value of Stock Meaning

Fair value is the intrinsic value of stocks. It helps investors to decide whether to purchase or sell shares at the appropriate price. Moreover, knowing the fair value of different stocks shall help you to invest in the right stock based on market conditions.

If the price of a stock is below its fair value, it is called undervalued. Contrarily, it’s called overvalued if the stock price is higher than its fair value. This investment strategy focused on the assets' fair value is referred to as value investing.

Example of Fair Value

Now that you know the fair value definition, let's take an example to understand the fair value of assets. Assume you are building a new factory. Considering its resale value, the shop will bring in Rs. 70 lakhs in its 30-year lifespan. You wouldn't want to invest more than Rs. 70 lakhs to build this factory as there would be a loss.

Further, you will recover a significant portion of the Rs.70 lakhs after a long time. Therefore, currently, you should invest quite less than Rs. 70 lakhs. In this case, the factory's fair value is the amount you are ready to invest in it right now. Making an investment at this fair value will help you to get reasonable capital gains.

Calculation of Fair Value

You may calculate a stock's fair value using methods like Discounted Cash Flow (DCF). The DCF model takes into account the concept of the time value of money. The method discounts future cash flows to determine present value. It considers this present value to determine the stock's fair value.

Here are the steps to determine the stock's fair value.

Step 1: Determine the present value of potential future cash flows for a few years.

Formula of present value = Σ [CFt / (1 + r)^t]

Here,

• Σ shows the sum of all future cash flows.

• CFt stands for the anticipated cash flow in a specific year (t)

• r is the discount rate

• t is the number of years

Step 2: Determine the company's terminal value. Terminal value is the total expected future cash flows beyond the prediction period. Typically, the prediction period is three to five years.

Formula of terminal value = {CFt(1 + terminal growth rate)}/(discount rate – terminal growth rate)*

The company's approximate rate of growth is the terminal growth rate. Now, apply the formula of present value to the terminal value. This will give you the existing terminal value.

Step 3: Add the values obtained above. This value is the final fair value. To get the equity value, deduct the debt from the company’s value.

Example:

Here’s an example of fair value calculation using the discounted cash flow (DCF) model. Let's say you expect a company ABC to generate the following cash flows over the next five years:

Year 1: Rs.800

Year 2: Rs.1,000

Year 3: Rs.1,200

Year 4: Rs.1,400

Year 5: Rs.1,600

Using this data, let’s calculate the fair value now.

Step 1: Suppose the discount rate (r) is 8%. Then the present value of ABC's stock is as follows.

Fair Value = Rs.800 / (1 + 0.08)^1 + Rs.1,000 / (1 + 0.08)^2 + Rs.1,200 / (1 + 0.08)^3 + Rs.1,400 / (1 + 0.08)^4 + Rs.1,600 / (1 + 0.08)^5

= Rs.800 / 1.08 + Rs.1,000 / 1.1664 + Rs.1,200 / 1.2597 + Rs.1,400 / 1.3605 + Rs.1,600 / 1.4693

= Rs.740.74 + Rs.858.37 + Rs.952.38 + Rs.1,029.63 + Rs.1,096.34 = Rs.4,677.46

Step 2: Let’s say, the terminal growth rate is 5%.

Hence,

• Terminal value = Rs.4,677.46 * (1 + 5%) / (8% - 5%) = Rs.4,677.46 * 34.82 = Rs.163,279.79

• Present value of the terminal value = Rs.101,727.67

Step 3: Therefore, the final value of the company is = Rs.4,677.46 + Rs.101,727.67 = Rs.106,405.13.

Fair Value vs Carrying Value

Carrying value is the value of an asset as recorded on a company's balance sheet. Whereas, fair value is the theoretical or intrinsic worth of a stock. Here are the key differences between fair value vs carrying value.

Advantages of Fair Value Accounting

There are several benefits of finding the fair value of stocks. The important ones include the following.

• Transparency: Fair value offers a more transparent picture of a company's financial health. It considers the actual market and economic conditions rather than market fluctuations.

• Risk Assessment: It takes into account discount rates in the valuation process. Hence, it enables investors to evaluate the risks more accurately.

• Adaptability: Apart from stock, investors can also use this method to determine the fair value of other assets like bonds.

• Beneficial in both bear and bull markets: Sometimes the price of many stocks declines or increases as a result of significant market changes. Understanding the fair value will assist you in controlling your emotions and adopting a balanced strategy.

Factors Affecting Fair Value

Several factors can impact a stock's fair value. They are as follows.

1. Profits and growth: A company's fair value will increase based on its profits and cash flow growth.

2. Economic conditions: Economic factors comprise interest rates, regulatory frameworks, technology advancements, and geopolitical events that may impact the company's future earnings.

3. Risk: Higher risk levels due to the company's high debt, uncertain profits, or low cash flow may force you to change your discount rates. As a result, the stock's fair value decreases.

Conclusion

Investing in fundamentally strong stocks is crucial for long-term investors who want to ensure wealth creation in the long term. You may find the fair value through fundamental analysis and compare it to market value to pick the suitable ones. Investors can select an appropriate valuation method based on the type of stock and the investment period. However, remember to take into account your investment goals and risk tolerance while selecting the stocks to invest in.