The emotional side of asset

Certainly one of the most notable masterpiece in MoMA that I've got the chance to see during my last trip to New York in August 2013 - I love using art to provide a different angle into valuation.

Certainly one of the most notable masterpiece in MoMA that I’ve got the chance to see during my last trip to New York in August 2013 – I love using art to provide a different angle into valuation.

Let’s start with Elon Musk’s wealth.  I started to notice Elon Musk’s net worth since he announced his ambitious Hyperloop project.  In March 2013, his asset was USD 2.7 billions according to Forbes; now in August 2013, his asset is USD 7.7 billions according to newest Bloomberg estimate.

What makes his net worth increase from USD 2.7 billions to USD 7.7 billions in a few months?

This is, at its core, a question about value of an asset – which is measured by a certain acceptable valuation methods.  One of the biggest mistake a person (mostly investor/financial analyst) can make is to believe there is a hard-scientific way to value an asset and that the value of an asset can be found precisely and correctly based on a well-crafted valuation method such as net asset value or discounted cash flow.  The truth is, no such thing exists: the value of an asset depends on how much people willing to pay for it. Going further, there must be a base for people to decide how much they are willing to pay for it, such as the future cash flows of the asset to compensate for the price the buyer is paying today.  That is an absolutely sound approach however not common.  The most common approach is: Value of an asset = Perception of that asset value.  Thus, the whole valuation game is the game of making other people’s perception.

The next question is: How to make other people’s perception?

How to judge if Mark Zuckerberg’s offer to Instagram of USD 1 billion is a correct valuation of Instagram? There will be debates.  However, if Mark offers to buy 40% of Instagram with the price of USD 400 millions (implies USD 1 billion for the whole valuation), Instagram will have very little incentive to sell to other investors some percentage with the value, tangible and intangible, less than Mark’s offer.  And the market benchmark of Instagram value will immediately jump from whatever previous valuations to that USD 1 billion mark.  That’s the power of price of the recent offer.  How does the market perceive the value of Instagram? It’s the Mark’s willingness to pay USD 1 billion.  How does Mark base his valuation? There are only a few people know exactly why, not even includes Paul Graham of YCombinator.  What is the benchmark value of Instagram in the market? USD 1 billion.

There is one critical aspect to note – that this deal is a private deal and the result of the deal is highly negotiated.  In a highly negotiated environment such as the private market where Facebook and Instagram operated before Facebook going public – value of an asset can run (and change) quite dramatically from one side to another.  At the same time when Facebook bid its offer to Instagram, Sequoia’s offer was USD 500 millions.  Sequoia brought into the table another market’s perception of the value of Instagram and if Instagram had accepted Sequoia USD 500 millions before Facebook’s offer, probably no one in the world would ever mention the USD 1 billion mark.  In a more liquid market with a more transparent price discovery mechanism, value of an asset (such as a listed company in a stock market) is much less choppy and less hard to grasp.  That being said, this does not mean assets in a listed market such as stock markets is not emotional.  The game just changes from emotions of a few people to emotions of the crowd.  However, one thing must be noted is that there is probably less room for penalty for wrongful decisions made due to emotions in a listed market comparing to a private market.  This is because the buyer will just resell to another buyer in that listed market with some transaction costs and perhaps with a certain small price disadvantage.

On the other hand, all above examples are from private market: should we care about private market? The private market, actually, matters much more than the listed market, even in the scale of the U.S. economy.  Total the U.S. listed equity market capitalization at the end of 2012 is approximately USD 18.7 trillions (Worldbank), meanwhile the U.S. total net worth (total asset minus total liabilities in all sectors) at the end of 2012 is around USD 91.7 trillions (Fed) – implies the total size of private market in all sectors in the U.S. economy is nearly 80%.  With GDP of USD 16.6 trillions in 2012, stock market to GDP ratio of the U.S. is 112%.   The U.S. market is already one of the most transparent market in the world.  Looking back at Vietnam’s economy, no one knows exactly how much is the country’s net worth but the Vietnamese stock market to the country’s GDP is only 24% (USD 33 billions of market capitalization (Worldbank) to USD 138 billions of 2012’s GDP (IMF)).  If we just make a simple assumption that Vietnam’s net worth to Vietnam’s GDP is equal to the U.S.’s net worth to the U.S.’s GDP of 5.5x (local perception is that Vietnam’s figure must be higher due to the tradition of hiding and keeping the asset private), then total Vietnam’s net worth will be around USD 760 billion and implies private equity assets value (net off all liabilities) account for 96% of total assets net worth.

I suspect we will still see the private market matters much more than more transparent form of markets in the future.  Especially if taking into account emerging and frontier markets where opportunities are still being hidden.  By that, negotiation will continue to play at a central role in value/price discovering.  Watching private deals created, killed, and invested even in an institution environment, I realized how much emotions come into play in all investment activities: from deal source, due diligence, to valuation.  Finally opportunities do not float around in the sky with the clouds.  They are in the hands of some people.  Before involving into any deal, first question asked will be if you really want to do business with that person.  And to answer that question, there have already a lot of emotions involved.

11:05 PM – Sep 1st 2013, Presidential Club 1960

Tri Ton

Businessperson with private equity expertise. Interested in strategy and investment.

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2 Comments:

  1. Which is why I can run 5 different financial models, but at the end of the day the majority of my private equity deals are negotiated and closed on comparables.

    • So true – it’s much easier to explain your position with comparables to both counter-parties and the market. Still, a well crafted DCF that captures all value drivers is my favorite way to see all opportunity and risk from internal perspective.

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