Real Effects of Subjectivity in Measuring Fair Values

ABSTRACT This study examines how the subjectivity in measuring fair values of assets without readily observable market prices affects investment efficiency and shareholder value. When fair values are objective measures of asset value, they facilitate efficient investment decisions that align with shareholder interests. In contrast, firms' reliance on subjective valuation inputs causes underinvestment in long‐term projects. If fair values are highly subjective, they may lead firms to favor less profitable short‐term projects with objectively measurable fair values. When project returns are positively correlated, subjectivity in valuing long‐term projects induces overinvestment in short‐term projects with objective fair values. Regardless of these distortions, fair value measurement can add shareholder value. Not measuring fair values altogether leads to underinvestment, which moderately subjective fair values can alleviate.