Fair market value is the amount a stock is worth on the open market. Fair market value generally incorporates the following assumptions:
- Buyers and sellers are reasonably knowledgeable about the asset in question.
- Buyers and sellers are seeking to further their best respective financial interests and are not under pressure to act.
- Buyers and sellers can execute their transaction in a reasonable time frame.
Importance of fair market value
Fair market value comes into play with gift or capital-gains taxes. If someone is given stock as a gift, then the fair market value of the stock on the day it is received will have tax implications when the stock is subsequently sold.
Let's say your uncle gives you some shares that he purchased for $5 each, and on the day you receive them, their fair market value is $10 a share. This means your uncle's cost basis was $5, but yours is $10. When you sell that stock, your own cost basis will be used to determine your capital gains or losses. For example, if you later sell the stock for $12 a share, then your capital gain will be $2 per share ($12 sale price - $10 fair market value on date of receipt), rather than the $7 share it would have been without the adjustment to the cost basis ($12 sale price - $5 original purchase price). So in this case your capital gains, and therefore your capital-gains taxes, are reduced.
This cost-basis adjustment based on fair market value can also work to your benefit when you sell gifted stocks at a loss. For example, if you sold the shares your uncle gave you for $8, then you could claim a capital loss of $2 per share and use that to lower your tax burden, even though the shares' fair market value represents a gain of $3 from the price your uncle originally paid.
Similarly, if someone chooses to assign shares of stock to a given charity, then the ensuing tax deduction will be based on the fair market value of those shares on the day they are donated.
Fair market value versus book value
Book value is the price paid for a particular investment or asset. Fair market value, on the other hand, is the current price at which that same asset can be sold. Book value and fair market value can work together to help investors determine how much they stand to gain or lose by selling off assets. If the book value of an asset is greater than the fair market value, selling will result in a loss, but if the fair market value is lower than the book value, selling will result in a gain.
Fair market value for publicly traded stock
Determining the fair market value is relatively straightforward for stock that is traded on a public exchange. In such cases, the fair market value is calculated by taking the average of the highest and lowest selling prices of the day. If fair market value needs to be established for a non-trading day, then the averages from the day before and after may be used instead.
Fair market value for private stock
Figuring out the fair market value of non-publicly traded stock is more complex because, unlike public stocks, there is no daily pricing data upon which to base calculations. Analysts use a variety of methods to determine the fair market value of private stocks, the most common of which is to compare valuation ratios of a private company to those of a comparable public company. Elements such as risk factors and future growth also tend to come into play when calculating fair market value for stocks that aren't publicly traded.
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