Alternative definition: Here, we are talking about the fair value of an investment from the perspective of an individual investor. Fair value is treated differently in a financial reporting context, and is sometimes specifically defined by state law for use in legal matters. Alternative name: Intrinsic value
How Fair Value Works
Before we jump into the determination of fair value, it’s important to understand that the fair value of an investment is an estimated, or potential, value and requires some assumptions. It is not a precise calculation of the true value of an investment. To the extent that the assumptions you make differ from reality or are different from the estimates someone else makes, then your estimate of fair value will be different. For stocks, the relevant cash flow is the stock’s dividends, and the most common discounted cash (dividend) flow model is the Gordon Growth Model.
Determining the Fair Value of an Investment
To see how it works, let’s look at the following equation using a simple example. The intrinsic value of an equity is calculated by dividing the value of the next year’s dividend by rate of return minus the growth rate.
P = D1 / r – g
(Here, P = current stock price, D1 = value of next year’s dividend, g = constant growth rate expected, and r = required rate of return.) Suppose the stock in question is expected to pay a $2 dividend, the discount rate is 8%, and the expected growth rate is 6%. The stock’s fair value is $100. But what goes into the estimates of future dividends, discount rate, and expected growth rate? Future dividends can be estimated based on the company’s dividend history and by considering how the dividends have grown over time. This would give you your expected dividend growth rate (g), and you would also use this information to calculate the next period’s dividend (D1). For example, suppose you look at the last five years of dividends and see that they have grown an average of 6% per year. Provided you reasonably expect that growth rate to continue in the future, you could let g be 6%. You would increase the most recent dividend by 6% and that becomes D1. In our example, let’s say our last dividend was $1.89. Because we expect that to grow by 6% over the year ahead, then our expected dividend in the next period would be $1.89 x 1.06 = $2. What about the discount rate? The discount rate can also be thought of as the required rate of return for an investor. Several factors influence the required rate of return, or hurdle rate, such as the rate of interest you could earn on risk-free government bonds, expected inflation, liquidity, and how risky the investment is. The more favorable these factors are for the investor, the lower the required rate of return; the less favorable they are, the higher the rate of return an investor would require. For our hypothetical example, we are saying that based on our assessment of each of those rate-of-return factors, we would have to think we could earn 8% by investing in the stock or we wouldn’t do it.
Fair Value vs. Market Value
Fair value is an estimate of what an investment could be worth in a competitive and free market. Market value is the current value of the investment as determined by actual market transactions, and can therefore fluctuate more frequently than fair value. Fair value is also calculated based on a chosen estimation model such as a discounted cash flow model that requires the investor to make some assumptions about the model’s inputs. Because market value is an observed, actual value, no assumptions are necessary. You use it by comparing the fair value of the investment against the current market price. Again using our example of a stock for which we estimate a fair value of $100, we would obtain a current price quote on that stock. If it is below $100, say $92.50, then this method of analysis would suggest this is a stock we want to buy because its current market price is lower than what we estimate it is worth. On the other hand, if the current market price is above $100, $104.75, for instance, then we would not buy it because it is currently overvalued. To illustrate that this is only an estimation and that the assumed values of your inputs have a significant impact on determination of the fair value of a stock, let’s see what happens when you change one of your inputs. Suppose you change your mind and decide that the investment is a little riskier than you originally thought. Instead of an 8% required rate of return, you decide that 9% is more appropriate. That means you only value the stock at $66.67. That’s a big difference. Now, even at $92.50, you would reject this investment based on this model. Why? Because you’d have to pay $92.50 for something that you now determine has a fair value of only $66.67. It’s no longer worth the price.
