Share prices DO NOT denote actual value. Hence things like the P/E (Price to Earnings) ratio. Share prices denote estimated worth, which is often never the case (some companies trade at 30x their actual earnings, and never live up to the promise of those expected earnings). The same concept applies to public/private acquisitions.
What is actually going on with these valuations? Well, it is kind of a way of conning public markets into buying this stuff. Even in the case of "private" acquisitions, these acquisitions are largely or entirely funded with publicly-traded money used by the publicly-traded acquiring company.
This is not always devious but I suspect there are at least a few cases of corruption. Sometimes companies are innocently acquired with the true belief that they will add value. Often times, companies are acquired to simply be "flipped" - i.e. destroyed within 3 years after the shares vest. The valley floor is littered with the skeletons of acquired companies. :)
[Edit: on reading further down, the author hints at this a bit).
There is an entire field of academic study dedicated to answering this question. While you may not be wrong, this is far from a settled issue. The confidence with which you make the assertion (in all caps even) doesn't really jive with the actual science being done here.
If you're interested, start with the efficient market theorem and work your way forward.
I understand what you are getting at, but what I meant (and I should have clarified, my fault) - by actual value, I mean current (i.e. not estimated or anticipated) value - rather, empirical value based on hard evidence (the books, preferably non-cooked version ;) ). The value that companies are traded at does not reflect their current value -- if it did, trading would be kind of meaningless, like placing bets on a finished race.
That said, you are correct - the free market basically determines a "real" anticipated value of a product, even though this value may be inflated or deflated by fear, hype, fake volume, other factors.
Not exactly. The strong-form efficient market hypothesis, for instance, suggests that the value of something in a unregulated and truly public market would fully capture all information in existence about a company.
The market is therefore a reflection of ACTUAL value, not anticipated value. The actual value.
Again this is a hotly debated hypothesis, but what the value of a company on a public market actually means is most definitely up for debate.
I think you are confused by what 'value' is. 'Estimated worth', as you put it, is value.
There are many ways of attempting to value a company, including looking at the discounted (and estimated) future cash flows, but they do not tell the full story.
For example, as an avid skier, I might be willing to pay $1000 for a better pair of skis as I will get more out of the ski. A beginner skier would see no increase in utility in my skis over a $200 pair. So, what's the value of the expensive pair of skis? Well, to me it's at least $1000. To the beginner, it's no more than $200.
The same holds true for companies. DCFs and multiples are useful hints at understanding the value of a company, but ultimately, they are insufficient. Companies can see strategic value in acquisitions differently, including the value of shutting it down (either because of concerns of competition or to acqui-hire the team).
On the public market, shares will more closely represent a discounted cash flow view of the future, but not always. The author's point about different share classes is also valid on public markets where control does not always go to common shareholders. That said, it's extremely hard to fool the market, as you've suggested. There's a ton of data to confirm that the market is exceptionally good at pricing the value (probability weighted against tons of factors) of future cash flows based on all current market information. There is a ton of data to support this, and very little to dispel it.
FMV defined from my textbook recollection: Highest price at which property will change hands between a willing and able buyer and a willing and able seller, acting at arm's length and under no compulsion to transact, in an open and unrestricted market and with full knowledge of the relevant facts.
Check all those boxes off and you can say: "YES, I'VE CALCULATED THE FMV!" but the truth is you can never be sure that you've determined the ONE TRUE FMV(c).
There should be only once price at which the property will change hands. Any less, and there would be competing buyers. Any more, and the buyer may have more attractive purchase options. This assumes that it's not a fire-sale, and that the property isn't a unique must-have asset, i.e. that your 'no compulsion to transact' condition is satisfied.
That analysis is hard to do correctly if the company is not even generating revenue... Unfortunately it has now become standard practice to use what is basically goodwill (hype, or more charitably, brand equity) as the primary value proposition for many startups.
Goodwill is something you add to the value of a company to sweeten the pot during acquisitions but it should never be the primary value proposition.
> Goodwill is something you add to the value of a company to sweeten the pot during acquisitions but it should never be the primary value proposition.
What? Goodwill is an accounting name for the excess paid to acquire a company beyond the fair market value of its assets. It's a "stub", basically used so that the books balance in terms of debits and credits (i.e. you paid X cash for the company, and that value splits between FMV of its assets and the rest is "goodwill".) Nobody ever says "I'm going to add some goodwill to sweeten the pot" when buying a company, nor would anyone attempt to use it for determining purchase price.
Are you referring to "Modern Meaning"? Maybe I'm not understanding what you're saying. It seems like you're implying that "goodwill" is a material part of the calculation of a purchase price prior to the deal being signed.
That is indeed what I am saying...what good will (no pun intended:) ) it be post-deal signing?...if you read that section "Modern Meaning" you see it alludes to brand,customers and IP...in the case of zero-revenue startups that translates to hype,users and maybe an iPhone app.
The gp is using the strict accounting definition of goodwill, you use it in its popular meaning. Strictly speaking nobody values goodwill before a deal, but it's often used as a word for 'the soft stuff we find hard to quantify'.
Maybe... but nobody really thinks of it that way, any more than they bother to worry about what fair market value of the assets (the other part of the purchase price) is for an early-stage tech company. They just care about the overall price, and they leave splitting that into FMV and goodwill as an exercise for the accountants after the deal is done.
A service company (i.e., a law firm) being acquired would almost exclusively depend on goodwill for the accounting of the transaction. There are few fixed assets beyond desks and chairs and possibly a property lease to include as assets. Accounts receivable and cash would of course play a role, but that is likely a fraction of the overall value paid. The difference between book value and the price paid is accounted for through book value.
Even in a steady-state in which Snapchat is earning serious money, were it to be acquired, the acquirer would likely need to account for it predominantly through goodwill. What tangible assets does snapchat have? Data center/infrastructure is likely the only area where a company like snapchat could invest in a way that would increase its book value... but snapchat is more likely to stay on the cloud...
The typical tech startup has few tangible assets, hence the necessity to account through book value.
Interesting analysis, but isn't goodwill a fudge-factor in the balance sheet? ie, its not a flow but a stock. This makes its estimation implicitly data-starved, because with a DCF at leat you are getting a time series of independent measurements.
No. Few companies are worth their exact book value. Accounting a balance sheet in of itself does little to tell you the true value of the company. For example, Google's book value is roughly 100B while its market cap (the implied value of the company) is 360B. Why the discrepancy? Accounting rules are strict on how assets are valued and don't (nor are they meant) to represent the future cashflow that can be derived from them. Future growth, intellectual property and brands are basically not included in the book value. When a company gets acquired, this difference is made up through goodwill. This is simply a representation that book value is not a good measure of true value.
Actually, in the case of a change of control (e.g.: acquisition), you will recognize fair value for brands and other identifiable intangible assets on the balance sheet. The Goodwill becomes the remaining difference between the consideration (purchase price) and the FV of the net assets.
Funny thing is that I'm actually working on a purchase price allocation right now.
>> This makes its estimation implicitly data-starved, because with a DCF at leat you are getting a time series of independent measurements.
It isn't a data-starved number. It is often as simple as DCF calculation of value - the book value. DCF isn't used to calculate book value. Book value is simply the sum of the tangible parts.
Then goodwill isn't the right word for it, because goodwill has a precise definition that isn't fudged.
Additionally, the author made a good point in that many investors are not buying straight common shares. You can't simply value those shares by doing a DCF. You need to value each component of the instrument (an option, equity, debt,etc.) to get to a final number. He's right that extrapolating out that number is incorrect, but it's also incorrect to then deduce that anything beyond DCF is 'fudged'.
Share prices DO NOT denote actual value. Hence things like the P/E (Price to Earnings) ratio. Share prices denote estimated worth, which is often never the case (some companies trade at 30x their actual earnings, and never live up to the promise of those expected earnings). The same concept applies to public/private acquisitions.
What is actually going on with these valuations? Well, it is kind of a way of conning public markets into buying this stuff. Even in the case of "private" acquisitions, these acquisitions are largely or entirely funded with publicly-traded money used by the publicly-traded acquiring company.
This is not always devious but I suspect there are at least a few cases of corruption. Sometimes companies are innocently acquired with the true belief that they will add value. Often times, companies are acquired to simply be "flipped" - i.e. destroyed within 3 years after the shares vest. The valley floor is littered with the skeletons of acquired companies. :)
[Edit: on reading further down, the author hints at this a bit).