Price or Value? Bases of Valuation
For many professional investors identifying a delta between price and value represents an opportunity for profit. For valuation professionals however, these dual concepts often become blurred. In this blog we consider the practical and theoretical challenges arising from the distinction between price and value in the context of commonly applied bases of valuation.
In simple terms the price of an asset is the quantum of consideration required to acquire it. Basic economics deals with pricing - all former economics students will have fond memories of drawing supply and demand curves to locate the equilibrium price.
For exchange traded assets price is easy to observe. Looking up the value of a quoted share is as simple a quick Google search. Where assets are not freely traded on open, liquid markets, however, establishing price requires specialist input.
Regardless of how simple it is to establish price, the factors that drive price are usually opaque, consisting of an almost infinite range of potential factors, both rational and irrational. The dot-com bubble which developed prior to 2000 is an extreme and oft-quoted example of irrational market behaviour but smaller scale and less press-worthy price fluctuations occur every day. The range and variability of factors at play can make price highly volatile.
For the practitioner, price is generally most associated with the market multiples approach. Multiples can be based on either equity value or enterprise value, earnings or assets. The appropriate type of multiple will be driven by the facts and features of the target. Multiple-based techniques most commonly rely on quoted prices and do not explicitly consider the long term risk and return profile of the target business.
Whereas pricing can be driven by all kinds of factors, including market sentiment, many think of Value as “what the price should be”, based on underlying factors. Value, or more specifically intrinsic value, is defined by Investopedia as the perceived or calculated value of a company, including tangible and intangible factors, using fundamental analysis. Increases in value arise where there is an increase in expected returns or a decrease in risk. Value decreases result from lower expected returns or increased risk. In theory, the moods and momentum shifts which have such an impact on price should not impact value.
Valuation, as distinct from pricing, is typically associated with the discounted cash Flow (“DCF”) approach. The valuation specialist has a range of DCF models which can be applied: pre-debt free-cash-flow-to-firm, post-leverage free-cash-flow-to-equity or dividend based approaches. All these models are explicit in their identification of return (i.e. the base cash flow) and risk, expressed through the application of the discount rate.
Stock market investors will often seek to identify the delta between price and value, buying undervalued stocks and hoping the market will realise its error and reprice at the “right” value. This approach to investing is referred to as “fundamentals analysis”.
Equity analysts, issuing buy, sell or hold advice are the most obvious proponents of this approach. Similarly, academics like Professor Damodaran, widely respected and heavily relied upon by valuation practitioners, is a practitioner of fundamental analysis.
Standing in opposition to fundamentals analysts, proponents of efficient market hypothesis (“EMH”) contend that assets in a liquid market will always trade at fair value as price will always incorporate all available information. If this is accepted, it follows there cannot be divergence between price and value and it is impossible to identify “undervalued” stocks. Critics of this approach will point to apparently irrational behaviour in markets, for example, the 2008 financial crisis, bitcoin, etc, and examples of star investors who have consistently beaten the market.
Market Value IVSC/Fair Value IFRS 13
Every valuation exercise must confront the reality that both price and value can vary depending on the identity of the parties involved. To get around this issue and promote consistency in valuations standard setters invoke the “hypothetical market participant.”
“Market value” under the IVSC guidelines is defined as “…the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm's length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.”
Similarly, IFRS 13 – Fair Value Measurement defines fair value as “…the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e. an exit price).”
In both these bases of valuation the theoretical distinction between price and value is conflated. The terminology of “value” is adopted. However, a fundamentals analyst would contend neither of these bases deal with valuation at all. Rather they are pricing standards, concerned only with what an asset could be sold for at that point in time.
This has interesting connotations for the valuation specialist. Common practice often follows the logic of these bases of valuation with practitioners making little distinction between price and value. DCFs are often employed alongside multiples for market value valuations. Indeed, given inputs and assumptions are explicit and easily sensitised in a DCF, this methodology is often given primacy over a multiples approach. Plenty of time and effort is spent to ensure that differing methodologies agree and mutually support the final valuation conclusion. If EMH is accepted and price and value are necessarily the same number, this reconciliation is a necessary and sensible task to undertake to get to the right answer.
If it is accepted however, that price and value can diverge it could be argued that the default position should be to place greatest reliance on market multiples. This would guarantee alignment - a pricing approach for a pricing basis of valuation. Similarly, the effort spent reconciling and triangulating methodologies is at best unnecessary and at worst, spurious.
IAS 36 - Value in Use vs FVLCTS
Despite the relaxed approach standard setters have with respect to price vs value terminology, they are not blind to the conceptual distinction. IAS 36 is the key standard that deals with asset impairment. Impairment tests are typically required for companies holding goodwill on the balance sheet, although impairment reviews relating to other intangibles are also common.
IAS 36 gives the asset owner two separate bases of valuation from which to choose:
- Value in Use (“VIU”) – the present value of the future cash flows expected to be derived from an asset or a cash-generating unit.
- Fair Value Less Cost of Disposal - amount obtainable from the sale of the asset in an arm’s length transaction between knowledgeable and willing parties, less the costs of disposal.
The higher of these two bases represents the recoverable amount which is then compared to book value to assess whether any impairment is due.
VIU is distinct from the fair value “pricing” under IFRS 13 and is more aligned to the traditionally understood concept of valuation outlined above. Consequently VIU is always calculated using a DCF approach. An entity’s VIU may be higher than the price at which it would be sold. For example, buyer specific synergistic benefits would be reflected in an assessment of VIU, but would be excluded for the purposes of any “fair value” assessment. Conversely, it is possible that an entity’s VIU would be lower than fair value where the asset is not being operated on a best and highest use basis.
Fair Value Less Cost of Disposal (“FVLCD”) is essentially identical to IFRS 13’s definition of fair value, with an additional deduction for costs of sale (IFRS 13 explicitly excludes transaction costs). Analysis performed on a FVLCD basis is typically performed using a multiples approach, but a DCF is also often adopted.
IVSC Fair Value
Fair Value under IVSC is defined as the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties.
This basis of valuation is therefore another interesting example of one which uses both price and value terminology without clear distinction. The conceptual basis is first and foremost price, i.e. what would be paid by the buyer and accepted by the seller. However, given the requirement to incorporate the respective positions of the actual parties involved, market multiples – the technique most associated with price - may be inappropriate.
A DCF would give the practitioner the ability to adjust cash flow or discount rate to account for the individual positions of the parties involved. DCFs are, however, a tool associated with intrinsic value. Analysis performed on this basis is therefore likely to implicitly accept the EMH hypothesis that price and value are indistinguishable.
The interplay between commonly applied bases of valuation and the concepts of price and value is complex, touching on fundamental academic disagreements on how markets work. If the EMH is accepted, all practical distinction between price and value falls away when dealing with valuations invoking the hypothetical market participant. Practitioners should, however, be aware that data prepared by fundamentals analysts (Damodaran, equity analysts) has not been prepared to assist in the calculation of an equity’s current market price, but rather to identify value - what the price “should” be.
Away from pure IVSC-style market value analysis, intrinsic value as a concept separate from price remains critical. Where a practitioner is performing VIU or IVSC Fair Value analysis there must be a very careful consideration of “non-market” value drivers – what they are, whether they impact value and at what sort of quantum.