The abyssal difference between value and
price
Why “CoCo” and “CoTra” won’t help you
Sometime I like watching documentaries on
“real life” pawn shops. There is a lot going on: interesting characters
visiting the shop, the most diverse objects offered for pawn or sales (from
Americana to Viking swords, music instruments or firearms), a lot of side
stories. The reason why I like watching this programs is the negotiation part
among the pawn shop employees and the clients. I must admit that for me this is
every time a great learning experience. I learn a lot and I use what I learn
for M&A discussions, when I hire someone, when I am looking for a job
and/or negotiate with my customers.
How
so?
The typical scene is the following: A
potential client walks in and offers to sell or pawn some objects. The clients
try to keep the price as high as possible arguing on rarity, uniqueness, or
market value of what they bring in. The pawn shop guys obviously try to
negotiate the asking price down. Normally there is some discussion going on,
sometimes both parties argue about provenance, rarity or similar and very often
an expert is called in (typically for old books or guns) to examine the items.
The negotiating parties are far apart as
long as they are talking about different things at the same time: price and
value. The seller would like to agree on the highest possible price, at
which normally there is no value left in for the buyer. The buyer then start
speaking about the price he or she is going to sell the item in the shop for.
When the parties recognize the value which is intrinsic in the
transaction for each party, then it is very easy to determine a dollar amount,
a price, to agree upon.
Even among very qualified counterparts
there is quite a bit of confusion between price and value. I use a very simple,
almost obvious sentence to clarify what I am talking about:
Price is what you pay, value is what you
get.
Do you think this is trivial? You should
think again. In numerous M&A transactions, parties on all sides tend to mix
up these two different concepts. When you have to figure out the value
of a company you would like to acquire, there is only one way to determine your
decision. What you would like to know BEFORE acquiring a company is how much
cash will remain in your hands after you pay a price, align the target to your
operation, and perform the necessary investments and cost cutting. And this in
the short, medium and long term[1].
What should really matter to you is the
amount of money which you, at the end of the day, can make with this
acquisition. Incidentally: your advisors may also recommend you to
purchase a company for “strategic” reasons, for example to access certain
markets or take over important customer agreements. Accept to do so only if the
cash you expect at the end of a reasonable period of time is more than the
amount you have in your pocket before the transaction.
Here another piece of advice you will never
find in any business book:
every time someone uses the word
strategic, you should consider replacing it in your mind with the word
“expensive” (alternatively: “very expensive”).
The world will start immediately making
a lot more sense to you if you do so.
Back to our pawn shop scenery. If the guys
clients and shop employees would speak from the beginning about the value, the
money each of them can make with the transaction, there would be an outcome
almost immediately. In the note below I have described the same scene twice:
the typical one and the alternative one if both parties spoke about value and
price at the same time. If you are
into this kind of show please check the footnote2]
In a nutshell: there is an abyssal
difference between price and value. Recently I have seen a company paid 3 digit
million USD amount and incapable of generating a single digit positive cash
flow. The price was shooting away from the value based on CoCo, CoTra and love[3]
Besides other effects, one of the most
misleading bias when acquiring a company is considering CoCo and CoTra as
valuation methods.
CoCo stands for Comparable Companies
and CoTra for comparable transactions. There is someone out there who charges
you a lot of money for giving you a list of CoCos and CoTras with the purpose
of justifying and substantiating their way off valuation (and fees).
These guys (mostly in good faith) mix up valuation and pricing and bring
in their assessment of a transaction similar companies which have a value x on
the market or other companies which have been sold for a certain price.
Mixing
price and value ain’t a good thing
Here is an example why it shouldn’t be
done.
A German guy some time ago happened to own
an old car, a VW Golf, which used to belong to Mr Ratzinger, a Cardinal from
Regensburg. When Mr Ratzinger was elected Pope of the Roman Catholic Church,
the car became an interesting object and was auctioned and finally sold for
188.938 Euro und 88 cents to an Online Casino. The value and the price of such
a car in the German market is typically fairly below 10,000 Eur.
I am exaggerating a bit on purpose, but the
guys using CoCo and CoTra as valuation elements are telling you that if you
want to buy or sell a used VW Golf you need to keep in mind that one was sold
for over 189 Thousand Eur. Or that the value of certain VW Golf can
reach the same amount.
Although I personally find it very
interesting to find out how much the Pope’s car has been sold for, or what is
the market value of a similar company, at the end of the day the only thing
I care is: if I buy this target, am I better off in term of cash in the short,
medium and long run[4]?
This
is a CLEARCUTCASE©: CoCo and CoTra won’t help you,
At
all.
(Unless
you would like to pay for them as conversation items)
In a nutshell:
1. When valuing an
acquisition think cash only
2. If you hear
“strategic” please understand “expensive” or “very expensive”
3. If someone is
showing you CoCos and CoTras you run the very big risk to confuse price and
value.
4. If the
individual above is charging you for this analysis please do contact me: I have
a lot of recommendation on how to spend your monies for personal fun or social
benefit
I am at your disposal
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[1] Here my warmest recommendation ist you use the net present value of the free cash flow method-and nothing else![2] Consider the typical scene:Pawn shop guy: “hey man, how are you doing?”Client: “hi dude, howrudoin, I brought a gun, a peacemaker. It belonged to my grand grand father who was a famous sheriff in the orange county. ”Pawn shop guy: “what do you want to do with it, pawn or sell?”Client: “sell it”Pawn shop guy: “how much do you want for it?”Client: “10,000 USD (price). It is a great affective value for us”Pawn shop guy: “that is not gonna happen, the peacemaker go for no more than 2,000 USD (price). Can you prove it belonged to sheriff xx”?Client: “no, but my parents told me so and I trust them”Pawn shop guy: “I can give you 1000 USD (price) for it?”Client: “no man, it is too low (value), you just said it is worth 2,000 USD (price)”Pawn shop guy: “that is the auction price on a good day. I need to buy the gun, restore it for 500 USD. It will sit here for months and I can hope to sell it for 2,000 USD (price)?Client: “can you do 1,100? ”Pawn shop guy: let us split the differencehttp://www.francescodibari.euNow the same scene in the perfect world:Pawn shop guy: “hey man, how are you doing?”Client: “hi dude, howrudoin, I brought a gun, a peacemaker. It belonged to my grand grand father who was a famous sheriff in the orange county. ”Pawn shop guy: “what do you want to do with it, pawn or sell?”Client: “sell it”Pawn shop guy: “how much do you want for it?”Client: “how much you can sell it for?”Pawn shop guy: “2,000 USD” (price).Client how much would it cost you to restore it?Pawn shop guy: 500 USDClient: “OK man, 1,100 (value) for me-I found this piece of junk in the basement, so any amount is fine, 400 for you (value)Pawn shop guy: “can you do 1,000? ”Client: let us split the differencePawn shop guy: deal![3]The buyer fell in love with the target- please read my previous post[4] I am referring to people who live very long or believe in a life after death or at least do not believe in Keynes theories. “In the long run we are all dead“ (J.M. Keynes)
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