Price and Value – the inseparable twins

One of the developments that got a lot of attention during the lockdown caused by the pandemic was the contrast between the struggles of many people to find two meals a day at one end and the astronomical rise in valuations of several individuals and businesses, especially start-ups, which have yet to go public. It was almost as if there are two completely different worlds. While this is not a new phenomenon the stark character of ordinary lives during the pandemic just made it seem bizarre. In fact, this is perfectly normal in imperfectly functioning market economies. I wrote a short post in LinkedIn on this titling it ‘Real miseries, theoretical values’. What I didn’t mention but should have is that ‘theoretical values’ have directly practical consequences. And this is where I see its links to price and the role they both play in an economic system that we call a market economy. Just recall the valuations that many start-ups in India have received over the last two years.

I am not going to be able to exhaust any explanation here because there is a lot that cannot be easily explained. For instance, what sort of projections that help justify the kind of valuations (of start-ups, especially) we continue to see in India. Or is it some factor other than projections that have unleashed these valuations. Or why is that real businesses get much lower valuations compared to service aggregators using technology. And how do we explain this volume of liquidity. I can go on to raise many more points but that is not the purpose behind this piece of writing. Hopefully, subject to the constraint of my own understanding and my understanding of others’ work, I will visit aspects that I will likely miss out now. For now, my principal point is that price and value are the dominant factors in any market economy. One decides how resources are used and the other determines how capital is allocated. Together, they decide the fate of an economy.

In mainstream economics which exalts the position of the market as the arbiter and downplays the role of any other variables and grudgingly allows a ‘role’ for governments in certain circumstances, the principal means through which a market regulates the use of resources is price. What gets made and what gets dropped all depend on price or rather prices of goods and services. More solar panels get made because the prices reflect a growing demand. In a system where the government takes over control of the economy as has happened in some countries and especially during times of war, this decision is made by a group of people in government authorized to take such decisions. You need to just study both Great Britain and Germany during World War II to understand what I am saying.

And what is value? There are many answers to this question depending on where you stand in the divide in economics – micro, macro, Marxian etc. I am using value here as the price of capital and as the result of a process of valuation. I will explain, although it is not an original idea. Just as everything has a price arrived at in some way, capital is no exception. There is a difference though in the way its price is ‘determined’. Value lies in the eyes of the one undertaking valuation; there is more than one process of valuation and different businesses emphasize different variables and assigning different weights. For example, in the business of retail telecommunications, the important variables could be cost of acquiring new customers, average revenue per user, attrition rate (customer churn) and so on. Let me state simply that there are several techniques used in valuation and each has its own advocates. Whatever the specific method, which is not our concern here, it yields a figure that is ‘Value’, which helps businesses decide whether, where and how much to invest or which business to acquire.

Any value which results in investment has to be recovered – never forget; this holds the clue to the link between value and price. Twenty years ago, a leading paracetamol brand was acquired by a rival pharma company at what many considered was a high valuation. Soon after, the price of this paracetamol was doubled. How else was the acquisition was going to recoup its purchase price? According to an article in The Wall Street Journal “Activist hedge fund Elliott Management Corp. has a more than $1 billion stake in Citrix Systems Inc. CTXS 0.73% and wants the software company to take action to boost its lagging stock price, according to people familiar with the matter. Elliott recently informed Citrix it has a stake of more than 10% in the company and would like to work with it to improve its valuation, the people said” ((https://www.wsj.com/articles/elliott-management-has-a-more-than-1-billion-stake-in-citrix-systems-11631059080?mod=hp_lead_pos4). Both examples should clearly show the link I am talking about.

Years ago during the .com hype, Time Warner (which owns CNN) acquired AOL at a humongous valuation only to write off $54 billion some years later as subsequent events rendered the acquisition price uneconomic; in simple language, Time Warner lost money because it could not recover what it paid for. You will find many such examples not just during the madness of .com but earlier and later too. Even today. If you look at the valuations of some of the food order aggregators, you wonder how investors will recover their investment. And, more important, what will ensure the recovery. Clearly, either they have to extract more discounts from suppliers (which is one way of pricing) or charge customers for the service. Or hope that sheer volumes will open up more business leading to greater profits. Else, there is no way that the investment (valuation) will be recouped and this is the link between value (or valuation) and price that I emphasized earlier and doing so again.

It is this umbilical cord that guarantees the recouping of valuation. Once this connection is broken, which means that subsequent pricing of goods and services is inelastic, the valuation is shown as hopelessly off the mark. But what price are we talking about – full cost pricing, strategic pricing, demand based pricing leading to target costing or what? I will write on pricing sometime later.

To sum up, the next time you read about what seem attractive valuation, you ask a basic question – what will ensure its recovery?

Takeaways

Value is the result of valuation

There is a close link between price and value

Recouping of investment (valuation) depends on the link functioning