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Thursday, July 14, 2011

Fair Value 101

FAQ On Fair Value
1.     What does fair value mean anyway? Simply put, it means the price which you could sell an asset in an active market to an unrelated party
2.     Why do we want all assets to be at mkt value? The high P/B ratio shows that there are several off balance sheet assets like intangibles, human capital, fixed assets at market value etc. The attempt to have fair value tries to capture the holding gains(due to inflation) and the market value gains
3.     But why do organizations oppose it then? Firstly, valuation is specialized work needing accountants, valuers and auditors-all of whom charge hefty fees. Secondly, companies are exposed to market volatility even for assets they do not intend to sell(brands, goodwill, fixed assets, long term financial isstruments). Next, not all markets are equally active-the framework mainly relates to the Anglo Saxon financial markets model. Lastly, if the market moves against them(as in the subprime crisis where financial instrument holders had to take heavy losses on their securities inventory), those organizations WILL object
4.     What is the way out? Increase the proforma information(some cos are doing this for brands,  fixed assets and people). Secondly, have a few broad impairment tests to ensure that risky assets atleast approximate their conservatively estimated fair value . Essentially, Separate valuation from accounting.
5.     But liabilities value can only fall(since liability is capped). Why do we use fair value there? See, companies love fair value for their liabilities because discounting will only reduce the value. Also, if the financial position of companies worsen, thus making it likelier that they will default(viz increase in own credit risk), they can reduce the value of their debt-thus increasing equity accordingly. Read ‘credit value adjustments for more details’
       As an user of fair value accounting, what should I realize? Unless the asset has an actively traded market(listed securities etc) AND the entity is both willing and able to dispose it off, there is no sense in informing investors the fair value. This applies more so in the case of closely held companies, where even if the minority investors know that stakes in listed group companies/factory land etc alone much exceeds the current market cap, they cannot compel the management to liquidate and return the cash to them.     How reliable are these valuations? In the mecca of investing(USA), the same valuation firm felt that $2 and $10 were fair prices for Bear Sterns, in the space of weeks. This is not an unique incident, valuation is nothing but a story agreed upon by valuers, operational management and accountants. Even market quotes sometimes are to be taken with a pinch of salt, especially if the reporting entity is itself a major market player/maker. 
       But won't this spur investor activism? Maybe-but only if there is a sufficient free float. Otherwise, promoters will see their holdings value rise, without even taking corporate actions.

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