Fair value is the value of a transaction between two parties that reflects open and willing negotiations. It can be challenging to calculate fair value if there are no clearly observable market prices. In general, fair value calculations fall into one of three categories. The first involves using market prices that are quoted on a transparent and liquid exchange of some kind, like a stock market. The second category uses comparable prices for assets that are very similar to the asset under valuation. This often applies to homes and cars. The last group is theoretical, and uses the discounted cash flow method to determine fair value.
Calculate Fair Value With Comparable Information
Determine the fair value of 1,000 shares of a public company’s stock by using the Internet or a major newspaper to find the last closing share price for the stock. For example, if the stock closed at a price per share of $50 yesterday, then the fair value of 1,000 shares is 1,000 x 50 = $50,000.
Determine the fair value of a house for sale on a given block by researching the sales prices of similar houses in the neighborhood. For example, if three homes recently sold for specific prices, and these homes are very similar to the home being evaluated, then use the average of the three sales prices.
Add the sale prices of the three similar homes and divide by three. For example: 225,000 + 250,000 + 245,000 = 720,000; 720,000 / 3 = 240,000. The estimate of the fair value of the home in question is $240,000.
Calculate Fair Value With Cash Flows
Use the discounted cash flow method for an investment that creates a series of cash flows for which there is nothing comparable or similar.
Write down the cash flows of the investment. For example, a $100,000 investment that produces $25,000 annual cash flows for five years will be written down as: (100,000); 25,000; 25,000; 25,000; 25,000 and 25,000.
Write down 1+ an assumed rate of return that is expected for this investment next to each 25,000 payment. For example, if the assumed rate of return is 5%, then write down 1.05 next to each 25,000.
Raise each 1.05 to the power of each year of that cash flow using a calculator. For example: 1.05^1 = 1.05, 1.05^2 = 1.10, 1.05^3 = 1.16, 1.05^4 = 1.22 and 1.05^5 = 1.28.
Divide each 25,000 cash flow by the corresponding discount factor for each year. This produces five discounted cash flows of: 23,810; 22,676; 21,596; 20,568 and 19,588. Add these five numbers to -100,000, which was the original investment. The result is 8,237, which means that using a 5% rate of interest, the fair value of this specific investment is $8,237.
Tom McNulty is a consultant and a freelance writer based in Houston, Texas. He holds degrees from Yale and Northwestern, and has worked in banking, government, and in the energy industry. McNulty has published several articles for eHow on a variety of finance, accounting, and general business issues.