Price, cost and value: not always the same!

Valuers are generally tasked with estimating market value by a definition that looks like this: the price that would be achieved between a willing buyer and a willing seller acting without compulsion in a reasonable timeframe. And let's not forget, price does not always equal value, something explored in this previous article.

In order to estimate this price, valuers use common valuation methods known as cost, income, and market. There is an economic law, the Law of One Price, that assumes that in certain types of markets, these estimates will all converge on one price.

However, this assumption doesn't always hold in the real world. It requires that markets are competitive, liquid, knowledgeable and in equilibrium.

Law of one price assumptions may not be real world

Let me give you examples of how these economic assumptions may not hold in common situations:

• Competition. Certain types of companies offer different propositions to segments of the investment markets.?This is like the way that consumer products companies might monopolistically compete, competing in different segments in those consumer markets. This means that the possibility of a perfect substitute between investments is often avoided-diluting the effect of competition.
• Liquidity. Those who remember the GFC, will be aware that in certain markets, liquidity completely dried up.?This broke the link between income and market prices, so securities (and other assets) traded well below fundamental values.
• Knowledgeable. Many investors are in fact price-takers from the market. And in some cases, may not be informed about the alternatives available to them.
• And of course, equilibrium. Sometimes in investment markets, as in other markets, there is an excess of either supply or demand. If there is an excess of demand, investors may be able to derive a greater value than what costs (and incomes) might be. Or conversely, in conditions of excess supply, costs and incomes might be greater than the market price.

Other common challenges

Even if the assumptions above hold for your situations there are also common challenges with each of these cornerstone valuation methods.

For example, in the cost method, sometimes risk, normal profits and opportunity costs are not included when they probably should be.

Alternatively, the market method has pitfalls when the chosen benchmarks are not perfectly comparable. Depending on the adjustments made for the differences, and the exactness by which these adjustments can be computed, misestimation can occur. ?In addition, valuers can and do differ across types of market for almost identical assets, and if you ignore these market differences challenges can arise.

In the income method, there can be an incorrect allowance for risk, the inclusion of private advantages/disadvantages or plain old exuberance, as we often see from time to time in investment markets.

Takeaways

Cost, income and market are common valuation methods.

If used interchangeably, they rely on the Law of One Price result in equal estimates of market values.

In the real world, this is often the case.?In this reality, valuers and investors alike need to be aware that estimates of market value might differ widely in these circumstances.

Whilst in the long-term these indicators of value are likely to converge, in the short-term, they may not.

In addition, even market conditions mean the values should converge, they may not due to the common challenges with the application of the different valuation methods.?If this happens (and good practice in valuation suggests that performing cross checks from multiple methods is desirable, so the comparison should almost always happen) the valuer should consider whether they have correctly evaluated market conditions or correctly applied their chosen method.

__________________________________________________________________________Richard Stewart OAM is a Corporate Value Advisory partner with PwC. He has been with them for 36 years in Australia, Europe and the USA, doing his first valuation in 1992. He has helped his clients achieve great outcomes using his value skills in the context of major decisions, M&A, disputes and regulatory matters. His clients span both the globe and the industry spectrum. He holds a BEc, MBA, FCA, FCPA, SFFin, FAICD and is an accredited Business Valuation Specialist with CAANZ. He has written two books, Strategic Value, and Hitting Pay Dirt, and is an Adjunct Professor at UTS. The opinions in this article are his own and not necessarily PwC's.