The price is right


Cynics know the price of everything and the value of nothing. When is there a difference between value and price?

“A cynic”, said Oscar Wilde, “knows the price of everything and the value of nothing.” But how does someone less cynical know what value is? And when is there a difference between value and price?

I am not sure whether actuaries are cynics. They value equities by discounting the value of the expected stream of future dividends. Gordon Brown’s abolition of the tax credit reduces that stream by one sixth. Does it really make sense to knock 17% off the value of shares when their price is at an all-time high?

There is a well-established, liquid market for shares. That makes it difficult to justify substituting an opinion about value for a price. If the price and the value of an asset differ, why don’t you buy or sell it – and go on doing so while the discrepancy persists? If actuaries really have better information about the value of securities than the market, why aren’t they, and their clients, rich?

There is a practical defence of actuaries. Market values are volatile. A long-term activity, such as funding pensions, should not be deflected by every market tremor. But this confuses two issues. Do not respond too quickly when market values change. But you do not achieve that by kidding yourself that market values have not changed.

Surveyors often make the same mistake. Have you been told that a building is worth £5m on a willing seller/willing buyer basis, but that in the current state of the property market you could not expect to realise that much for it? This is nonsense on stilts. It could be worth £5m if there were a willing seller and a willing buyer at that price. But it would equally be worth £10m, or £1m, or £10, or £1, if there were willing sellers and willing buyers at these prices. The only price which is of any interest at all, and the only one which gives any guide to the value of the property, is the one at which there really would be a willing seller and a willing buyer.

Like the actuaries, estate agents have been led by sensible objectives to silly results. Properties are idiosyncratic, and it may take some time for a suitable purchaser to come along. That distinguishes a willing buyer/willing seller valuation from a forced sale. But now surveyors use the concept to average out fluctuations in the economic cycle and to make it seem that the value of their clients’ portfolios are less volatile than market prices suggest. But once again, if they have better information about value than the price, why don’t they use that knowledge to their own advantage?

It is not just buildings that are idiosyncratic. Most business assets have the same characteristic. There are no markets in them, trade occurs rarely if at all, and so there is no price on which to base an estimate of value. You can summon an Expert to determine a value: chartered accountants, investment bankers, even brand valuation specialists. But their expertise mostly rests in knowing what answer they gave last time. On what do they – could they – base a valuation?

Take the extreme case of idiosyncrasy: an asset for which there is only a single buyer and a single seller. These are the facilities of a broadcaster or a train operating company that has lost its franchise; the assets of a sub-contractor whose plant is designed around the requirements of a single supplier; the use of a computer facility dedicated to a specific function.

In all these cases, you have a choice of valuation bases. Replacement cost is what it would cost you to build it if it were not there. Often you would not build it if it were not there; the Forth Bridge is an extraordinary feat of engineering, but no one would think of putting it up today. So you also need to think about economic value – what you might expect to earn from it. And every asset has a realisable value – what you would expect to get if you disposed of it to a third party; often only for scrap.

None of these concepts corresponds to the price that would be fixed in a transaction for value, although all help determine that price. Nor are any of them equal to the valuation base we see most often – depreciated historic cost.

Which of this multiplicity is the right measure of value? It all depends on why you want to know. To know what return is needed to justify new investment in an industry, measure value at replacement cost. To know what return is needed to keep capacity in an industry, look at realisable value. To judge the performance of the firm, turn to economic value and historic cost.

And remember two lessons when Experts offer a valuation. If there is a market price, there needs to be a very good explanation of why the value is different. Usually there is not. If someone offers you a valuation without asking the purpose for which his valuation is required, his opinion is not worth listening to.

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