The Effect of an Increase in Fair Value on Total Shareholder's Equity

by Dennis Hartman

Determining the value of a business is a key concern for investors who weigh multiple options before becoming shareholders. While no estimate of current or future value is entirely accurate, standardized accounting formulas allow investors to measure the value of assets in several ways. Concepts such as fair value and shareholder's equity describe how much a business is worth to its future and present owners.

Fair Value vs. Market Value

Fair value is an economic concept that describes the expected value of an investment at some future point in time given a number of considerations, such as the cost to hold and sell the asset, the risk involved and the expected rate of return. Fair value is different from market value, which reflects the current market price of an investment asset based on what actual buyers and sellers are willing to agree to. However, current market value plays a major role in calculating fair value using one of several formulas that incorporates the effects of time.

Impact on Equity

A company's shareholders' equity is the difference between the value of its assets and its liabilities. Because they are two distinct concepts, fair value does not have a direct impact on shareholders' equity. However, some of the same factors that increase fair value also drive up shareholders' equity. For example, when a company owns a patent that it begins to use to make a profitable new product, the fair value of its stock is likely to rise. At the same time, the value of its patent, which is an intangible asset, rises, pushing shareholder's equity up based on a new, higher estimate of the patent's value.

Issuing Stock

When a company issues new stock, or uses stock as a form of payment, it must account for the stock at its fair value. For example, some companies issue stock dividends, giving shareholders new stock as a reward for investing. However, since this stock has fair value based on its fair market value, giving this stock away causes shareholders' equity to decline. In this case, a rise in fair value would create a drop in shareholders' equity if the dividend remained the same.

Significance for Investors

In a financial market, fair value generally refers to the value of futures contracts to buy stock or a share of an index in the future. In this usage, fair value is a projection of future value based on a company's financial position. Decisions within the company, such as those to take on debt, invest in expansion, issue a dividend or retain earnings all impact shareholders' equity directly. However, the impact they have on fair value is up to analysts and investors who judge these decisions and estimate their effectiveness.

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