The fair value of a stock refers to its real potential value; it is an accurate expression of a company's actual worth and what a sound investor would be willing to pay for a share. That's why it is essential to know how to calculate fair value of shares.
How Are Fair Value Measurements Used?
Individuals and organizations use fair value in two main ways. The first major way that individuals and organizations use fair value is if they plan to buy or sell shares they own. Second, they use it to determine the value of assets held for accounting purposes. However, it is essential to keep in mind that any fair value measurement is fluid. Many volatile and unquantifiable circumstances play into finding it, which can change quickly.
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This concept exists separately from fair market value, which is more directed toward sales than fair value is. While these concepts are similar and sometimes even used interchangeably, there is a difference between fair value and fair market value. Because fair value takes the industry into account, it is a more stable figure. A single company's worth may fluctuate, but it usually stays relatively close to its industry standard, not going above or below certain parameters.
The first step is to calculate the price to earnings (P/E) ratio. You need two figures to calculate the P/E ratio: the current stock price per share and current earnings per share, both of which you can find by checking their listings on the appropriate exchange website. Next, you need to consider the entire industry that the company is a part of. After all, a company's value isn't determined in a vacuum. Calculate the P/E ratio for at least three or four, and ideally 10, other companies in your particular industry or one that's similar to yours.
The next step is to compare: see where your company falls when compared to others in the same industry. If your company has a high P/E ratio compared to the others, that means it is overvalued, and if its P/E ratio is lower than most, then it is undervalued. Now that you know how your share compares to others in the same industry, you can make any necessary adjustments.
You can use the calculated P/E ratios to adjust a company's fair value to the mean or median fair value of the industry or locate it somewhere in the middle. It is always vital to be clear about metrics used to determine fair value. To adjust the share price, multiply the correct P/E ratio by the earnings per share. That will give you the new fair value of the share or stock.
The Difference Between Fair Value and Fair Market Value
The biggest major difference between fair value and fair market value is that fair market value doesn't consider mitigating circumstances; it looks only at supply and demand. You do not look at the P/E ratios of other businesses in the industry or make adjustments. You may not even necessarily calculate the P/E ratio to determine a stock's fair market value. It is what one party is willing to sell it for, and another is willing to buy.
As you might imagine, the fair market value of a share is highly volatile and subject to change. It can change noticeably several times in a single day. However, that is not the case with fair value. That is why it is better to use fair value when determining net worth or calculating assets. It is also essential when considering or planning the purchase or sale of a stock, while fair market value is more relevant at the time of the sale.
Consider also: How to Calculate Changes in Fair Value Investments