Value, price or cost?

Guess what keeps business appraisers busy and well paid. The fact that business people confuse the value, price or cost of businesses and business assets. But these are different things. Who says? The market. In fact, the market is where many participants express their opinions each and every day.

So as your business appraiser would no doubt tell you, cost and selling price are not the same. Nor is value of a company the same as its current stock price may suggest.

When an appraiser creates a business valuation the result is an estimate of value. To do this the appraiser assumes a hypothetical business sale transaction in which a willing buyer and seller close a deal while acting in full knowledge and not under pressure to buy or sell.

Why do appraisers envision a business sale to do their work? Because business people rarely ask about their company’s value unless they are thinking about some transaction. Getting the number right to keep all parties happy is important.

The appraisers have their work cut out for them. Since many business people confuse value, price and cost, they often have trouble coming to an agreement. So the appraiser steps in to provide a reliable opinion of company’s value based on experience, knowledge and professional skill.

Why do business people confuse value and price or cost? Consider an example of a publicly traded company. Now, in an efficient market, stock prices reflect decisions by investors who form their opinions after gathering and analyzing the available information. In other words, investors as a group decide once they have full knowledge of what drives a given company’s value.

But why is it then that stock prices go up and down each and every day? Just because a stock price tanks does not mean the company suffered some unexpected setback. The investors tend to overreact quite often. As a result, the current stock price and company’s actual value may differ.

Another example of cost and price confusion for you. Imagine a building contractor telling you that building a spec house would cost $700,000. But what the contractor really means is the selling price. Rarely would private contractors disclose their actual costs to the clients. Unless, that is, the client is a big government and proving the project costs is a condition of getting the contract sealed.

Value of an asset also depends on who wants to know. Imagine someone shelling out $10 million for a painting. You may find the price exorbitant.

What surprises many business people is that the value result depends on the purpose of appraisal. For example, imagine you buy a car for $50,000 that the dealer discounts to make the sale. Now when you go to get your car insured, the policy should cover the replacement cost. But this will likely be higher, say $55,000. So what is the true value? Actually, both numbers work, each for its own purpose.

The actual price a business sells for may differ quite a bit from its fair market value. As any seasoned business broker would tell you, the price and terms both determine if a business sale is successful. Seller financing or generous lender terms may increase a pool of competing buyers. And this could result in a top selling price. On the other hand, your business may linger on the market because few buyers are looking or can afford it.

The moral is clear: careful use of the value, price and cost concepts helps you prevent confusion. Cost of a project and price of an asset may differ. Value in the long term may not equal price or cost. In valuing an asset or a business, you would do well to define what you mean by each of these terms in your particular situation.

See Valuation Tour