The difference between the price and the value of a company is simple, yet crucial. Knowing the distinction can mean having leverage during your next negotiation, the difference between making a bad or a great investment, or just simply making good conversation at your next dinner party. After reading this, you will be able to properly identify the difference between price and value in a negotiation.
Value is value?
Let’s start off with understanding value. Value can be broken down into two major sub-divisions: book value and market value. Book value is, as the name gives away, what is in the books. Accounting will show a company’s value by subtracting liabilities from the assets. What is left if a company were to sell off its assets and settle its debts would be the book value of that company. Book value is accounting value which is shareholders’ equity.
Fundamental value, or intrinsic value, is the estimated value of the firm based on the expectations of future cash flows. These estimates are based on an evaluation of earnings potential, investment needs, financing opportunities, business models etc. These are then adapted and inserted into a valuation model of your choice.
Finally, market value is the value of the company according to the stock market. The easiest way to calculate this is multiplying the number of shares with the current market price. This is also referred to as a company’s market cap. Market value is usually the value that is referred to by newspapers and analysts as it reflects how much you would have to pay in a purchase situation.
Fundamental value in the market
There are a couple of general principles when looking at the relationship between market value and fundamental value. When the fundamental value is larger than the market value, the market is for some reason undervaluing the company compared to its actual value. Many investors seek out these companies as they are viewed as a great investment opportunity. In the scenario where the market value is greater than the book value, the market usually has a firm belief in the potential earnings of a company. When market and fundamental value are equal, the market and your performed fundamental valuation are agreed upon the value.
Knowledge might determine the price
Moving on to price, i.e. the market value. The price of a service, good or business has for a long time been viewed as the compromise between what a buyer is willing to pay and the price a seller is willing to sell for. That logic is beautiful in its simplicity. Practically, there are several different factors that come together to determine the price. These include the number of interested buyers, the sense of urgency of the deal and the negotiation power of the involved parties.
Reaching an agreement
The bottom line is that both value and price will fluctuate during the life span of a business, and maybe especially so in a negotiation. The fundamental value of a business is primarily based on your belief and trust in the company. Do you believe in the company’s ability to grow and stay profitable? It also depends on the industry, and the timing – is there a peak in interest during a specific period in time? This might spike prices. To evaluate the price and decide on your willingness to invest, you have to weigh in all factors and establish a link between the fundamental value of a company, its accounting information and future prospects for the company. Based on that, the buyer and seller can hopefully reach an agreement on price – in all its beautiful simplicity.