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The Value of a Business: What Value Is, How Value is Created, and How Value is Measured

The Value of a Business: What Value Is, How Value is Created, and How Value is Measured

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Published by gccurrie
What Value Is, How Value is Created, and How Value is Measured
What Value Is, How Value is Created, and How Value is Measured

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Published by: gccurrie on Feb 19, 2009
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03/19/2013

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The Value of a Business:
What Value is, How Value is Created, and How Value is Measured 
George C CurrieIntroduction
“Value” is one of the most basic concepts in economics, philosophy, ethics andsociology, yet is perhaps one of the least well-defined and most misunderstood(Trotta 2003). This paper examines three main aspects of value as it may apply inthe business arena. It firstly provides a definition of value for business. It thendescribes the how a company creates value, and the operational, financial, andcorporate governance issues involved. The paper finally introduces the mainapproaches and associated methods by which the value of the company can bemeasured.
What is value?
It is not only true (if somewhat trite) to say that “value” means different things todifferent people, it is also necessary to recognize that value is dynamic, and that thesame person’s definition or interpretation of value varies according to changingcircumstances. The first step in exploring value must therefore be to identify thepurpose and limits of our definition of value.Throughout this paper the definition of value will be limited to its business sense.British Standard BS EN 1325-1: 1997: Value management, value analysis, functionalanalysis vocabulary, defines value as:
“The relationship between the contribution of the function (or VAsubject) to the satisfaction of the need and the cost of the function.” 
This relationship is commonly represented as:Value=Satisfaction of NeedsCost
 
This definition applies not only to the value of the firm’s products or services to itscustomers, but also the value those sales create for the company, and through thecash flow created from them, of the firm to its owners.The primary function of business is to sell a product or service to a customer, sincewithout that transaction none of the other functions of the business create value for its owners. At this individual transaction level, the customer has needs which heexpects the product or service to satisfy, and the firm is in business to produce aproduct or deliver a service and offers this to the customer at a price. The sellingprice either set or negotiated for this transaction is the buyer’s cost of the satisfactionof his need. In our definition, the value of the product or service to the buyer is thebenefit the buyer expects to obtain from it divided by its cost, and unless this isperceived to be greater than unity (i.e. the perceived or expected benefits exceed theselling price), there will be no sale. One of the main functions of the company’smanagement is to ensure that either the selling price of the product is kept lowenough, or its benefits as perceived by the target market are high enough, that it hassufficient value in the eyes of the buyer to ensure the sale.The expected benefits (and hence the value) that the buyer expects to obtain arehowever in most cases complex, and stem from either or both of the twocomponents of value identified by classical economics; “value-in-use” and “value-in-exchange” (Smith 1776), together with the more modern concept of “esteem-value”.All three of these components however, to a greater or lesser degree include asubjective element. Esteem-value is the buyer’s internal answer to the question“How much do I want it?” (SAVE 1998), and represents the amount he is willing topay for the perceived properties of a product or service which contribute to itsdesirability in his eyes. As such it is almost entirely subjective in nature. Value-in-exchange depends on the collective agreement of a society as to what the relativevalue of things are, which varies - both over time as societal mores alter, and fromplace to place between societies, and hence in any particular transaction dependsnot only upon the personal circumstances and preferences of the buyer, but also onhow he may anticipate these may change or how society may come to view theobject in question. Even the direct benefit that the individual may obtain from the useof the object or service may change over time (and sometimes dramatically and over 
 
a short period of time) depending upon the particular circumstance
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. Thesevariations affect the benefit that any particular individual perceives he would gainfrom the ownership of the object or receipt of the service, and hence his perceptionof its value-in-use at the seller’s price. When considering an individual object or service, its value therefore lies in the eye of the buyer and, although the price in atransaction may be set by the seller, value may only be determined by the buyer according to his individual circumstances, preferences and expectations (Tucke2002).Assuming that the business has a viable product or service to offer to the market,and that at least some of its target market perceive this to have value, the firm willmake sales and generate revenues. Each and every product or service sold by thefirm throughout its life thus makes some contribution to the cash that may bedistributed amongst the firm’s owners once it has paid all its costs and taxes. It is theanticipated existence of this cash flow from future sales that creates the value of thefirm to its owners. The
intrinsic value
of the business is therefore the sum of itsexpected future after-tax cash flows (i.e. the revenues expected to be generatedfrom its sales less the cost of the assets and other inputs used in their creation, andof the business entity itself), adjusted by a discount rate that appropriately reflectsthe relevant risk of the business, its products and its markets (McCarthy 2004).For privately-held businesses, their shareholder value is equal to the intrinsic value,however for publicly-listed companies their shareholder value is determined by thecapital market in which the shares are traded, and the company has a fluctuating
market value
” which is simply the share price at any time multiplied by the number of shares outstanding at that time. In a perfect capital market, i.e. one where allinformation is immediately reflected in the share price of the company, the marketvalue (and hence the shareholder value) equals the intrinsic value. In real lifehowever, the two may differ (in some cases markedly), either due to inefficiencies
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For example, an adventurous traveler whose boat develops a serious leak when crossing acrocodile- infested river will not place any value on the water which threatens to sink him, but wouldpay almost unlimited amounts for fuel to run his boat’s pump to keep him afloat until he can berescued or make it safely to shore. Conversely, the same adventurer whose 4WD breaks down whentraversing a sandy desert later in his travels will value the extra fuel he carries far less than he woulda supply of drinking water. The same two products, being employed by the same person, but havingdifferent values at different times due to different external circumstances.

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