Price and Value

With a house, you always hear that the value is whatever someone is willing to pay for it.  But with a house, that value setting transaction is usually for the whole thing.  Partial shares of houses do not usually trade on the market.  So with a house, there are long periods of time when the actual value of the house is an unknown value.  It is usually reasonable to use a process of comparables to value the house.

Partial shares of companies, on the other hand, are traded on open markets.  That gives us a Price to use to impute a value to the ownership shares that are not traded.  The theory is that the shares are all worth the same amount.

The total reliance of modern finance and accounting on traded Price is credited with major improvements in the way that we understand business activities.

But there are unintended consequences of this shift.  And traded Price has never been a perfect measure.

The major fact that should make users of finance and financial statements pause is that when there is an acquisition of a company, the buyer does not rely upon finance theory about market values to set the final price of the transaction.  They rely upon boots on the ground fundamental analysis of the firm through the process called due diligence.

And at the end of that process, there is almost zero record of any firm selling for anything like the market price that existed before the acquisition process became known.

The buyer of a firm knows more than the market and pays a different price than the market. But if traded Price was really what the proponents of its ubiquitous usage say, then the wisdom of the market crowd should have arrived at the same amount.  But it never does.

You can think of it as the market spinning its own myth of the value of a firm and running around trading small lots of stocks that may not have any real impact on the actual transactions for the control of listed firms.

What does that mean for a risk manager?  It means that reliance on traded price is risky.  Traded price is more like a mock casino night.  Everyone pretends like the traded price is the real value of the firm but everyone knows that at the end of the night it is all just a game.  Why is that risky?  Because, like any game, trading shares can be suddenly discontinuous.

The value of a firm is the amount of profits that it can create in the future.  Don’t let any traded price enthusiast tell you anything different.

Those traded price folks tried to sell the idea that a house was worth whatever someone would pay (with someone else’s money).  But in reality, the house can only be worth an annuity on a fraction of the earnings of the folks who live there.  Traders can temporarily come to a different conclusion.  And they can give each other Nobel Prizes for creating clever math around their mock casino night.

Explore posts in the same categories: Mark to Market

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