What Is Stock Fair Value and How Is It Determined?

Stock fair value is an accounting concept used to estimate the worth of a company’s stock for financial reporting. It represents a methodical assessment of value, distinct from the daily fluctuations of a public stock market price. This measurement provides a consistent basis for valuing assets on a company’s books, reflecting an asset’s underlying economic value at a specific point in time.

Defining Stock Fair Value

Guidance for fair value is found in the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 820. This standard defines fair value as the price received to sell an asset in an “orderly transaction” between “market participants” at the measurement date. This is an “exit price,” focusing on the hypothetical sale of the stock rather than its acquisition price. An orderly transaction assumes normal market exposure and is not a forced liquidation or distress sale.

Market participants are buyers and sellers in the principal market for the stock who are independent, knowledgeable, and willing to transact. This framework requires a company to consider how such participants would view the stock’s value. A clarification to this principle is that a contractual restriction on a security’s sale is not part of its fair value measurement, as the restriction is a characteristic of the holder, not the asset.

While a stock’s closing price on a major exchange is a clear example of fair value, the concept is broader. It provides a framework for valuing securities without a readily available market price, such as private company stock or thinly traded securities.

The Fair Value Hierarchy for Inputs

To bring consistency to fair value measurements, a three-level hierarchy is established for the inputs used in valuation techniques. This hierarchy prioritizes inputs based on their observability, with Level 1 being the highest priority and Level 3 the lowest. The classification of a fair value measurement depends on the lowest level of input that is significant to the entire measurement.

Level 1 inputs are the most reliable, representing quoted prices for identical assets in active markets that a company can access. An active market is one where transactions occur with enough frequency and volume to provide ongoing pricing information. A straightforward example is the closing price of a major corporation’s stock traded on a public exchange like the NASDAQ.

Level 2 inputs are observable inputs other than Level 1 quoted prices. This category includes quoted prices for similar assets in active markets or for identical assets in inactive markets. Other examples include interest rates, yield curves, and market-corroborated data. For example, valuing a private company’s stock might involve using the valuation multiples of a similar, publicly traded company, which requires some adjustment.

Level 3 inputs are unobservable and used when there is little market activity for the asset. These inputs reflect the entity’s own assumptions about market participant pricing, developed using the best available information like internal financial forecasts. Valuations for private equity investments or complex derivatives frequently rely on Level 3 inputs due to the absence of a public market or comparable transactions.

Common Valuation Methodologies

Accountants use several established methodologies to determine fair value, categorized into three approaches. The selection of a methodology, or a combination of them, depends on the availability of reliable data and the nature of the stock being valued.

The market approach uses prices and other information from market transactions involving identical or comparable assets. This can involve looking at the recent sale price of a similar company or applying market multiples, such as a price-to-earnings ratio, derived from comparable public companies.

The income approach converts future amounts, like projected cash flows, into a single present value amount. The most common technique is the Discounted Cash Flow (DCF) model, where future cash flows are forecasted and discounted to the present using a risk-adjusted rate. This method is useful for valuing companies with predictable cash generation.

A third method is the cost approach, based on the amount currently required to replace an asset’s service capacity, known as the replacement cost. This approach is more commonly used for tangible assets like machinery than for stock. While part of the valuation framework, it is not the primary method used to determine the fair value of a company’s equity.

Required Disclosures in Financial Statements

Companies must provide detailed disclosures about their fair value measurements in the notes to financial statements, such as those in an annual Form 10-K. This information helps a reader understand the inputs and valuation techniques used, especially for those not based on active market prices.

A feature of these disclosures is a table categorizing assets and liabilities measured at fair value into the three levels of the hierarchy. This table shows the amounts valued using Level 1, Level 2, and Level 3 inputs, allowing a reader to assess the proportion of values based on market prices versus internal estimates. Disclosures must also report any significant transfers between the levels.

For fair value measurements categorized within Level 3, disclosure requirements are more extensive. Companies must provide a narrative description of the valuation techniques used and the unobservable inputs that were significant to the measurement, such as discount rates or growth projections. Furthermore, for equity securities subject to contractual sale restrictions, companies must disclose the nature and remaining duration of these restrictions.