In accounting terms, value is the monetary worth of an asset, business entity, goods sold, services rendered, or liability or obligation acquired. In economic terms, value is the sum of all the benefits and rights arising from ownership.
The economic value of a business is the business’s contribution to the global gross domestic product (GDP). The most common method of estimating economic value is the counter-factual method. The counter-factual method states that the economic value of a business is the difference between the current global GDP and the hypothetical global GDP if the business did not exist.
Although it is a logically sound method of estimating economic value, it is often difficult to use in practice. Especially, the counterfactual GDP (i.e., GDP in a world where the business did not exist) is difficult to estimate.
An alternate method of estimating economic value is to only look at the first order effects of the business, i.e., the direct effects of the business on society. For example, we look at how much profit the business makes and how much tax it pays.
However, the alternate method ignores all higher order effects of the business. For example, the taxes paid by the business may result in the government cutting taxes in other industries, which, in turn, may result in growth in that industry.
Value vs. Price
The value of a business is usually derived through discounted cash flow (DCF) analysis. They are mathematical models that provide a valuation of a company by estimating and then appropriately discounting future incomes earned. DCF analysis provides an estimate of how much revenue the business is expected to earn over its lifetime.
The value per share of a company can be calculated by simply dividing the value by shares outstanding. When valuing a business, an analyst is trying to answer the following question: How much is this business worth in the market? Accountants tend to focus on stock valuations and consider owners’ equity as the most accurate estimator of the true value of a business.
On the other hand, financial markets investors tend to focus on flow values and consider net revenues as the most accurate estimator of a business’ true value. The market price of a business is the market’s estimate of the true value of the company. Since the market is composed of heterogeneous agents with rapidly changing beliefs about the business, the market price of a business fluctuates drastically (to reflect the changing beliefs).
In addition, the business’ market price is also affected by the state of the overall economy. It may increase during an economic boom (expansionary phase) and decrease during a recession (contractionary phase).
John runs a small business. The business owns assets worth $2,000. Consider an investor who offers to buy the business from John for $2,500. If only the value of assets is considered, it would be a profitable transaction for John. However, the business generates annual profits of $10,000. Therefore, the transaction is no longer profitable because it does not take into account the cash flow associated with the business.