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What's Fair Value?

Like many things that involve specialized knowledge, the world of investing is full of jargon. Usually, however, you can find simple explanations for terms by simply searching for them. For instance, if you watch the financial news before the opening bell, you may notice that the reporters sometimes look to the stock futures markets as a guide to what direction stocks will move in the first few minutes of trading. Often, someone will refer to the futures as trading "at a discount to fair value" and conclude that the market will open lower.

The term "fair value" refers to a relationship that exists between stocks and stock futures. Stock futures are used primarily by financial institutions as a convenient way to gain exposure to the price movements of a particular stock index, such as the Dow or the S&P 500. In general, when the underlying index changes, the stock futures will follow suit. However, because stock futures reflect the value of the index in the future rather than right now, the price of stock futures will differ from the current value of the index. Theoretically, this difference should reflect the length of time between now and the expiration of the futures contract, current interest rates, and the dividends to be paid on stocks in the index before the futures contract expires. The financial news programs do the appropriate calculations and refer to the result as fair value.

When both stocks and futures are open for trading, this difference in prices usually remains close to the theoretically correct fair value, because traders are constantly watching both markets for chances to profit from deviations from fair value. Because stock futures begin trading before the stock market opens, however, this arbitrage opportunity does not exist until stocks are available for trading. The resulting buying or selling pressure on stocks tends to push their prices up or down. So if the Dow futures are trading at a discount to fair value, the Dow will usually open lower. In addition, one might expect the individual Dow components, such as 3M (NYSE: MMM  ) or United Technologies (NYSE: UTX  ) , to open lower, as long as there's no company-specific news that would tend to push its price higher.

Fair value is useful primarily as a tool that lets financial commentators predict extremely short-term price movements near the opening bell.

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Fool contributor Dan Caplinger prefers to pay less than fair value for good investments. He doesn't own shares of 3M or United Technologies. The Fool has a disclosure policy.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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