Fair Value Vs. Market Value: Detail Explanation

Introduction

Often fair value and market value are used interchangeably and understood as the same thing; however, in reality, they are not identical.

There is a difference between these two terms; however, the meanings of these terms may be very similar under some circumstances.

To understand the difference between market value and fair value, we need to understand their meaning.

Definitions and Meanings

Market value (also called Open Market Value – OMV)- International Valuation Standards (IVS) defines the market value (MV) as the estimated amount/price for which an asset or liability should be exchanged on the particular valuation date between a willing buyer and seller in an arm’s length transaction, after properly marketing it and where both parties had each acted knowledgeably, prudently and without compulsion.

Explanation of Definition of Market Value
Estimated amount
An asset or liability should exchange
Price determination is based on demand and supply forces active in a market.
“On a valuation date” means that the value is specific to a given date and time. The estimated value may be incorrect or inappropriate at another time because conditions applicable in the market may change.
“between a willing buyer” refers to a buyer who is motivated to buy, but not compelled to buy. This buyer is neither eager nor determined to buy at any price. Such a buyer would not pay a higher rate than the market requires.
“and a willing seller” is neither an overeager nor a forced seller prepared to sell at
any price, nor one set to hold out for an amount not considered reasonable in
the current market.
“in an arm’s length transaction” is one between parties who do not have a particular relationship. The Market Value (MV) transaction is presumed to be between unrelated parties, each acting independently.
“after proper marketing” means that the asset would be exposed to the market most appropriately to affect its disposal at the best price reasonably obtainable.
“where both parties had each acted knowledgeably, prudently” presumes that both the willing buyer and the willing seller are reasonably informed about the nature and characteristics of the asset, its actual and potential uses, and the state of the market as of the valuation date.
“after proper marketing” means that the asset would be exposed to the market most appropriately to affect its disposal at the best price reasonably obtainable.
“and without compulsion” establishes that each party is motivated to undertake the transaction, but neither is forced or unduly coerced to complete it.

Fair value (FV) – requires determining the right price between two specific parties taking into account the respective advantages, disadvantages, analyzing future margins, future growth, and risk factor relevant to each party from the particular transaction.

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Although market value can meet these criteria of fair value, this is not always the case.

Fair value is frequently used when due diligence is undertaken in corporate transactions, where particular synergies between the two parties may mean that the price that is fair between them is higher than the amount that might be achieved in the broader market.

In other words, this is called “special value.” Market value disregards “special value,” but it forms part of the assessment of fair value.

Difference between Market Value and Fair Value

We can differentiate Market Value (MV) from Fair Value (FV) as following.

  • Market value is unstable and thus varies more than fair value. This instability is because various market forces are influencing Market Value, but the same is not the case with fair value.
  • Market value is based on current prices or most recent quotations while the fair value is independent of this.
  • Market value can be altered by changing supply and demand patterns; however, the fair value does not affect this.
NoMarket ValueFair Value
1Estimated price for which a property is exchangedDetermination of Right Price
2Price determination is depended on demand and supply forces active in a market.Price determination is based on specific advantages and disadvantage to both parties (not active in a market)
3A particular date of valuationA particular date is not necessary
4Between a willing buyer and seller (but not specific)Between specific parties

Fair value is a more accurate estimate as compared to market value. Although Market Value is determined between two knowledgeable parties, the external influence of demand and supply forces makes it a less accurate estimate of the asset’s actual value.

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Let me explain the term knowledgeable used in the definition of Market Value. If you want to buy an asset and you do not have knowledge about the price of the asset, the owner can deceive you and can charge you more.

Example:

An asset is a Cash Generating Asset (CGA) of an Organization A. There is an offer to sell such an asset by organization B. Currently, the value it holds in the Books of Accounts (BOA) is $1 Million. This value is called the Carrying Value.

The valuation report revealed that the Market Value of such an asset is around $2 Million. They both negotiate and mutually decided to value the asset’s price at $2.5 Million, which is beneficial for both.

The principal difference between Market Value and Fair Value is that the later does not disregard Special Value, and the former does.

An amount above the Market Value that would be paid by a Special Purchaser to reflect advantages arising from the combination of the interests that would not generally be available to purchasers in the market.

Application of Fair Value and Market Value

Most organizations now record their assets at fair value. Fair value is recognized globally, and the standards of accounting also accept it.

The organizations that use market value can still suffer from many limitations and shortcomings, and their value will not be globally accepted. Since market value is dependent on external forces of the market, it is not an accurate measure.

We consider fair value as the real value as it cannot be easily altered. Fair value is always adjusted with impairment to arrive at the intrinsic value. However, market value is negotiated between parties without logically determining the actual value of the asset.

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Conclusion

Fair Value: The price that is fair between both the parties. Mutually beneficial value with no effect of market forces.

Market Value: Demand and Supply driven price. All dependent on market forces.

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