Explaining Fair Value

When you’ve been working with the stock market for awhile, one of the terms that you may hear thrown around is what is called “fair value” or “fair price.” Now, the definition is self-explanatory; fair value is the a rational price that a stock is estimated to be at, based on risk, utility, supply and demand, and other factors that may have an effect on the value of said stock. But, there’s more to it than that. The concept of fair value is very important in understanding the stock market fully.

Fair value is calculated in the stock market by a basic formula. They take all of the 500 stocks in the Standard and Poor’s 500 index, add them together, add their interest, subtract dividends and divide by 500 to find a number. This number is then the “fair value,” which is, essentially, an average. This number is most often used to determine futures. Futures are just that: Future estimates and predictions. If futures are estimated above fair value, then it is expected that the stock in question is going to go up, if they are estimated below fair value it’s expected to drop.

First off, some theorists believe that if those in the market are transparent and honest, then market prices will be almost equivalent to fair value. This is referred to as the “efficient market hypothesis.” Investors react to what is happening to their investments relatively quickly, keeping the value of most stocks and bonds near the fair value price. The other school of thought believes that efficient market theorists are a little too optimistic about human nature.

Is fair value useful? Incredibly. You can make estimates, see if you really are getting a decent deal on a current stock, and determine if it’s time to buy or sell using fair value as a marker. But, it’s not wise to bet the farm based on it; make sure that you do your research of other aspects of the market before you make definitive decisions.