What Is Stock Market Fair Value?
Stock market fair value is used in two ways. The first is the price difference between the stock market futures value and the individual stocks that make up the index. This difference is referred to as premium.
The second use is in fundamental analysis where investors attempt to value a stock in future years using different valuations and then compare that value to the current price of a stock.
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Stock Market and Futures Market Fair Value
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Stock market indexes such as the S&P 500 index can be traded three ways. Investors can buy for cash the 500 stocks of the index, they can buy for cash an exchange traded fund which holds all the 500 stocks in the exact weighted proportion, or they can buy a futures contract that represents the price action of the 500 stocks. With each trade of each of the described instruments there will be price discrepancies. The measurement that equalizes the difference between the futures, the ETF, and the 500 stocks is called the fair market value.
Fair Market Values are Constantly Changing
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Fair market value is constantly changing. When the exchange closes for the day the futures markets will trade before the next trading day's opening. If a trader believes the market will rise, he will buy futures increasing the premium between the futures and last close on the exchange. Just before the opening of the exchange, traders determine the premium or amount that the futures market implies that the physical (the 500 stocks) market must rise as a group in order to equalize the amount that the futures has risen. It takes massive computing capacity with extensive algorithms to compute such prices on an ongoing, near instantaneous basis.
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Fair Market Values Can Also Trade at a Discount
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If stock prices are falling, so will futures. In this case, it is said that futures are trading at a discount to fair value. If stock prices are unchanged on the day, futures and ETFs will usually trade at a slight premium to the 500 stocks themselves because of the effect of commissions and the leverage available in the futures market.
The Alternative Use of Fair Value
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Fundamental stock analysis is the use of balance-sheet data to determine the value of stocks. Cheap stocks are stocks that have assets that are undervalued or are worth much more than the value on their balance sheets. Expensive stocks are stocks that may have a high price and little earnings power to go along with it. In both cases, the real stock price is compared to an analyst's value. It is the analyst value that is called the fair market value. The buy or sell decision is made by comparing the current stock quote to that of the analyst's fair market value.
Fair Market Value in Accounting
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Fair market value in accounting refers to the difference in the value of a company's assets and liabilities in comparison to the price on the balance sheet. For example, railroad land purchased 100 years ago with track and buildings are slowly devalued each year to account for wear and tear. Even if the land and buildings decline in value the property is reduced or depreciated. Over time, large discrepancies may occur forcing the company to separate the accounting value of property against the real market or fair market value.
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