Par Value vs Fair Value: Everything you should know
The terms “par value” and “fair value” are often confused with one another, and it’s important to understand the difference between the two. Stock markets around the globe are constantly fluctuating, and it is crucial that you understand the terms associated with the financial sector in order to strategize, improve, and function within it. The main purpose of this article is to provide insight into the difference between par value and fair value by providing a few definitions, examples, and explanations for the two terms.
Par value and fair value
The par value of a stock share is generally determined at the time of its initial offering. A company will set the par value of its shares when it decides to go public, and this value is usually set to list it in the books and share certificates. After the company’s initial offering, the par value is rarely adjusted and will most likely be used through the end of its trading lifetime until stock splits take place.
On the other hand, fair value refers to the price determined for an asset by a willing seller and buyer. As such, it is the agreed-upon value of a stock, an option contract, a bond, or any other financial asset between two parties. However, it is essential to note that the fair value is different from the market value, which is defined as the price of the asset being transacted in the market typically based on the market forces.
What is par value?
The par value is also known as the “face value” or “nominal value”. It is the value of a stock that appears in its share certificates and books of the company. In general, the purpose of the par value is to simplify and standardize financial transactions for the balance sheet when the company is issuing share capital. The par value is usually set below $1 when the shares are offered to the public.
While no changes to the par value will be shown in the books of the company or share certificates due to the fact that it is a fixed value, however, in the case of a stock split, the par value might be changed. The decisions are taken by the top management in order to set the par value. In addition to this, this value does not have any bearing on the stock’s market price.
Is par value different for preferred shares and bonds?
In the case of preferred shares and bonds, the par value is affected by interest rates. Basically, when the interest rate increases, the price of the preferred shares and bonds decreases, and vice versa. This is because the interest rate is assumed to be a function of the risk of a financial asset. In addition to this, the par value of preferred shares is used to calculate the dividend, unlike the bonds. On the other hand, the par value of common shares is determined on the basis of market demand and supply.
How to calculate the par value of shares?
Typically, the par value is set below $1 and has no connection with the market price. Par value is set at the time of issuing shares to the public and is usually not adjusted until stock splits take place. As such, there is no mathematical formula to calculate the par value of shares. It is set by the top management of a company and will be determined after various considerations.
What is fair value?
The fair value is the price at which a willing buyer and willing seller agree to complete a transaction. It takes into consideration such factors as the risk of security, liquidity, market conditions, future prospects, and other economic factors. It is important to note that the fair value does not have any fixed value due to the fact that it is the value that is determined and agreed upon between the two parties.
While there are a few legalities, regulations, and guidelines in the computation of the fair value, all of them should fall within certain boundaries; however, it is more of a trading concept rather than a legal calculation. Employee Stock Option Plan (ESOP) is one such example of fair value computation, wherein the concept of granting options to employees can be determined based on the fair value of each option.
How does fair value differ from the market value?
Fair value is determined by two parties, usually an exchange, with the goal of determining the price at which a willing buyer and willing seller agree to complete a transaction. In comparison, the market value is dependent on supply-demand forces. The market value is a price determined on the stock exchange for security and is affected by various factors, including market trends, volatility, market sentiment, the company’s financial standing, and other factors.
The market value is typically transparent and available publicly, while the fair value is typically determined by a willing buyer and seller and is not readily available to the general public. Fair value and market value can be equal or different from one another. The fair value is often used to gauge the price of a security and is used by companies for pricing options and other securities, generally for private companies. In fact, fair value is often used by companies for private equity transactions because, unlike public companies, the securities are not publicly traded, and the fair value is not easily made available.
How to calculate the fair value of shares?
According to Generally Accepted Accounting Principles (GAAP), the Financial Accounting Standards Board (FASB) came up with a set of guidelines in an attempt to make the fair value calculation more consistent among private companies and public companies. Certain accounting techniques are used in fair value calculation. Generally, it is derived on the basis of the market or company valuation.
Advantages of par value vs fair value
While fair value is the price at which a willing buyer and a willing seller would agree to transact, par value relates to the price that the company has set for its shares. It is important to note that par value does not have any bearing on the fair value. As such, the par value suggests the minimum price of the shares, which can change based on various factors. The benefit of par value is that it is a standardized price for the shares. At the same time, it reduces the complexity for the company and its investors.
Furthermore, when issuing a bond, the par value serves as a benchmark price for the bond. On the other hand, the importance of determining the fair value increases the accuracy and reliability of share pricing. Both parties can be sure that they are getting a fair price. As a result, the applications of par value and fair value have their own advantages and uses.
The par value is more of a safeguard against the public’s perception of a company’s actual value, while the fair value is used as a pricing tool to set up the price. Therefore, the par value is a more conservative method of pricing because it is more geared to the actual market scenario, while fair value simply determines how much a willing buyer and seller are willing to pay.
Par value and fair value accounting
While there are a few things to consider when determining the par value and the fair value, here are some key aspects that should be kept in mind when it comes to determining both values:
Things to consider to calculate the par value of shares
In the case of an Initial Public Offering (IPO), it is important for companies to set the par value of the shares. That being said, it is essential to consider these three main factors:
- The initial capitalization target is traditionally the amount that a company intends to raise in the IPO. Based on that, the board of directors will set the par value in order to raise the intended amount of capital.
- It is imperative for the company to know how many shares it needs to offer to the public. As a result, the par value is determined on the basis of the number of shares that are to be offered to the public.
- The company should predict how the share prices will change before and after the shares are offered in the market. This will help set the par value of the shares.
Things to consider to calculate the fair value of shares?
When it comes to determining the fair value of the shares, there are some factors that need to be considered. Generally, the factors that need to be kept in mind include:
- Basically, the fair value of the shares is based on the predicted growth of the company. It serves as a key indicator of how much the company is going to grow in the future. In this regard, the company needs to consider the various factors that will influence future growth and subsequently determine the percentage of growth.
- The projection of cash flow for the next five years should be taken into consideration. In addition, the cash flows can be discounted to determine a present value. This helps to determine the fair value of the shares in regard to the cash flow.
- The terminal value of any security is the present value at a future point in time. This can be used to determine how much the stock is worth at that point in time. The present value of the terminal value is then discounted to the present value. Hence, this helps determine the fair value of the shares.
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In conclusion, par value and fair value are both very important tools in the financial world. They serve different purposes and, therefore, cannot be used interchangeably. It is important to have an in-depth understanding of these tools in order to know the share pricing mechanisms that work best for the company’s situation. Eqvista is here to help companies determine the fair value of shares and the par value of shares. The team of expert consultants at Eqvista has the knowledge and experience to help you develop an efficient valuation process. Get in touch with the experts today at Eqvista to get the professional assistance that you need.