30 Sep Knowing the Value of Everything but the Price of Nothing (Q3-12)

Edward Francis Hutton, the American financier who founded the eponymous brokerage firm E.F. Hutton in 1906, was revered for his ability to consistently buy assets on the cheap. On one occasion, while searching for land in the south to hunt on, he found a plantation named Hickory Hill for sale. After concluding a deal to purchase the property, Hutton said to the former owner, “Mr. Ravenel, it’s been nice knowing you, but you’re about the poorest businessman I know. I would have paid you twice the price for that land.” To which Ravenel said, smiling “I would have sold it for half as much.”

Valuation is highly subjective, even when there is a determined price. That is because as individuals, we make valuation judgments based on time, context, and our own unique perspective. It may be theoretically expedient to apply fuzzy mathematical models that generate seemingly precise value estimates, but failing to appreciate the subjectivity of valuation can be dangerous.

Take the example of the “expert appraisal”. The expert will apply various quantitative approaches to measuring value of an asset, including (i) determining the costs incurred to develop a similar asset, also known as cost-based value; (ii) observing prices of comparable assets traded between parties, also known as market-based value; and (iii) computing the present value of future cash flows of the asset over its useful life, also known as income-based value. Each of these approaches relies on assumptions of the expert and inputs that are subjective and uncertain. The expert retained will usually have direct experience in trading the asset or representing relevant industry buyers and sellers in similar transactions for which the appraisal is used. However, using an expert appraisal privileges the biases and assumptions of the expert over others, and the notion that the expert’s determination of value is “better” is purely theoretical.

Lenders rely on expert appraisals to determine the value of their security, a process that has become more heavily scrutinized in the aftermath of the financial crisis when many lenders learned the difficult lesson that realized prices can deviate substantially from appraised values. Asset appraisals are generally considered by lenders to be an insurance policy for their credit decisions, and are therefore used more frequently in lending situations that are collateral-dependent, such as for asset-based loans and during distress, default, or impairment. Of course, it is in situations like these that such an insurance policy will most likely have to provide cover, and the expert appraisal may be the lender’s best hope for an objective valuation.

The expert appraisal can be helpful but it ignores the perspectives, circumstances, and risk thresholds that are unique to the individuals making the choices. Time, context, and perspective are dynamic factors, and can quickly render an expert appraisal to be a utopian standard of value that is difficult to achieve. Trying to handicap the value of an asset is one of the biggest challenges faced by lenders today, especially since many companies’ most critical assets are intangible or even invisible on a balance sheet. We consider expert appraisals to be a proxy measure that establishes a mere starting point for estimating value. Expert appraisals should be the result of a lending decision, not the other way around. We develop real-world scenarios reflecting specific buyer behavior to determine the price that will be ultimately paid for our collateral assets, and update these scenarios on a periodic basis. We do this through discussions with liquidators, suppliers, competitors, and consumers of the assets being valued. This incorporates the factors of time, context, and perspective into our analysis, which can avoid us subjugating to the subjectivity of experts.

Value and price are rarely the same, but recognizing that value is unique and subjective can free lenders from the abstractions and models of expert appraisals, and achieve collateral price estimates that are married to reality. Lenders face a myriad of challenges and properly valuing assets should not be one of them.

Excerpted from Third Eye Capital Management Inc.’s Q3 2012 Investor Letter.