Value of a Business

It is basic valuation theory that the value of a business is equal to the present worth of the future benefits of ownership. This statement is a fundamental principle of business valuation. This is bolstered by the fact that, “a rational buyer normally will invest in a company only if the present value of the expected benefits of ownership are at least equal to the purchase price. Likewise, a rational seller normally will not sell if the present value of those expected benefits is more than the selling price. Thus, a sale generally will occur only at an amount equal to the benefits of ownership.”

In business valuations using the Future Maintainable Earnings methodology, we are determining the value of a business based on the value of an income stream. The methodology determines the value of the business and not the price at which it may change hands. The methodology makes no assumptions as to the price on sale. It represents the present value of the future income flows from the business. Value and price are often not the same, as price may reflect other benefits that ownership of the business may confer such as synergies with existing businesses, a job, the desire to be self employed, lifestyle decisions etc.

What is Price?

Price is what you pay for a given product or service. You buy a Suit that costs $1495. It’s cost is $1495. You decide to have your housepainted  before you sell it. This costs you $1200. It’s price is $1200. Simple as that.

What is Value?

Value is what any given product or service is worth. If the suit you bought helps you get a job with a salary of $150,000, It’s value is significantly worth more than the $1495 you paid for it. If painting your house gains you an extra $8,000 the value of the painting is $8,000 not $1,200

The Difference

Price is the amount you pay. Value is what the product or service pays you. This value could be measured in financial terms, emotional terms, physical terms, or in any number of other ways.

Let’s take a classic Adam Smith example of price and value and change it slightly. Consider the differences between gold and water.  We most certainly need water to survive, but we do not necessarily need gold to  survive.  Yet, we are willing to pay a much higher price for gold than a bottle of water.  Why?  Well that comes down to the ease of acquiring such a product.  Water is abundantly available on Earth.  Gold  require an intense amount of labour to extract from the Earth, and it is not readily available like water. However, during the Gold rush in Kalgoorlie water was selling for almost the same price as gold because of it scarcity.