Thursday, December 31, 2009


Or why are vacuum cleaners so expensive? (More on this later.)

Economists like to say that the value of a widget is the price on the market. For instance, when Nomura paid $100 million for a 20 percent stake in Wasserstein-Perella in 1988 it put the value of Wasserstein-Perella at $500 million. At the same time there is also the concept of willingness-to-pay so that if I were willing to pay $5 for a widget but the market clearing price is $2 then my consumer surplus is $3.

I take this as valuation using the market price is not always the best measure of the value of something. For the same reason, if I had to pay the market price for something even though it is not the amount I would like to pay then the valuation via market prices is not the best measure either. For instance, if I were interested in buying a piece of art and I had not bought art before the price I encounter for the first time would be meaningless. I would ridicule the idea of paying $50,000 for a few splotches of paint.

I could of course, investigate the art market and look at returns over time - but then I would be viewing art as an investment not as a pure purchase. Thus, the willingness-to-pay concept, is closer to what I think as valuation. How much do I value it? Yet, willingness-to-pay without actually having paid it is also meaningless. I could just as easily say that I am willing to pay $100 million to preserve biodiversity but the fact that I don't have $100 million makes this statement totally vacuous. This is even more true for the piece of art since it is the first time I am paying for it. And for goods which are unique, valuations are very difficult. I really really want it is as good a valuation as any because it conveys the fact that I am willing to pay a lot for it.

Since valuation is such a big business and such a slippery concept, I suspect that the numbers that consultants trot out at the end of the day are nothing more than educated guesses with wide margins of error. Even though acquirers of companies use these numbers and actually pay for these companies (of course, it's not really their money), these valuations I also suspect are pretty meaningless. Perhaps the acquiring CEO is overcome by the fact that he really really wants it more than anything else and the numbers are used to justify why he wants it.

When we purchased our house, it was listed as $350K. We ended up paying $335K for it. The bank sent some one over to value the house and lo and behold, it was valued at $335K. If we had paid $350K for it, I suspect the valuation would have been $350K. This example is not merely just to expose what a scam real estate valuations are but the entire field of valuation. Valuations are nothing more than a justification for an action that has already been taken. If the number had come in over the price we paid for the house then the bank would have been guilty of losing money on the deal. It should take the money itself, buy the house and sell it for the higher value. If the valuation had come in lower than the purchase price the bank would have been guilt of giving out a bad loan.

Unfortunately, valuations form the basis of every financial transaction and there is no way around this sordid mess. Of course, valuations can differ (and they do change over time - I may not want it as much tomorrow), and would be acquirers can be persuaded to change their minds after looking at the numbers but if he really really wants it then these numbers can also be changed to justify the acquisition.

I come through this thought via a very circuituous route - we are considering remodeling a room and although at the end of the day we are paying the price quoted (after due diligence of obtaining several quotes) it is till above what I am willing to pay. At the end of the day I am looking at it from an investment angle - that it would increase the value of the house although I am not positive it will.

P.S. Why are vacuum cleaners so expensive anyways? It is nothing more than a motor that sucks and they retail for around $200. Is the $200 model really that much better than a $400 model? I paid $300 for one and it was not what I would value the vacuum cleaner.

P.P.S. When I bought the diamond engagement ring I was guaranteed that the valuation would be over what I paid for it (and it was). I suppose this is to make me feel better.

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