Assets Are An Opinion

I have made a lot of money out of buying businesses where the current owners were either underestimating the value of their assets or, the more likely version, overestimating the value of their assets.  In the first case some owners do not think sufficiently outside the box to realize that their assets could be worth a lot more if they were combined with another customer database, for example, or enhanced with the addition of another line of products.  If I can realize the potential value of the undervalued assets, then buying them for a price that reflects their current owner’s valuation makes good business sense.

The second case often arises because the owners are being unrealistic about the effect of a change in market conditions to the value of their assets; the current property market is a good case in point.  People do not want to admit that the value of their house has gone down along with the rest of the market.  In the case of a house owner this need not be serious; they simply stay in the same house until things recover.  In the case of the owner of a business such unrealistic thoughts are potentially very dangerous.  Suppose I am looking at a business with assets that I think are worth £1,000,000, half the unrealistic value that the owner puts on them.  I offer, say, £900,000 and they reject it.  Three months later I notice that the business is still for sale.  I have another look and it is obvious that things have got worse and that the cash situation must be becoming serious. 

Do I repeat my offer of £900,000?  No I do not: this is getting close to what is known as a fire sale and I go in much lower.  If I have judged the precariousness of the owner’s situation correctly I will get the business for that lower price and the owners have cost themselves a lot of money by forgetting that the value of an asset is an opinion, not a fact.

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Tip from Shaf – It’s not rocket science
Business should be fun, but it’s serious fun.  Never over-ride your common sense in order to pretend that a situation is better than it is in reality.

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A jobbing builder has, amongst others, two assets on his balance sheet, a cement mixer purchased last year and being written off over five years and some bags of cement valued at cost.  His profits this year are only reduced by the depreciation on the cement mixer, 20% of its cost.  This is very different from its value; indeed it is highly unlikely that second hand it is worth the balance sheet value. 
Now go and look at the yard where the assets are kept.  It so happens that an apprentice emptied the cement into the mixer, added water, was called away to do something else and by an oversight left the cement in the mixer over the weekend.  It solidified, as cement tends to do, rendering the stock of cement unusable and the mixer unfit for its purpose.  What now should be the impact of these assets on this year’s profit and loss account?  We know, and so does the builder, that the value on the balance sheet should be written off now knocking a significant sum of money off the bottom line.  But this brings profits below expectations and would upset the bank manager.  So the builder wheels the mixer into a dark corner of the yard and everyone is happy.  The value of an asset is an opinion.

Reality strikes only when the builder needs cement and a mixer; it will cost cash to hire a mixer and buy the raw materials.  So cash is reality.