“Price is what you pay. Value is what you get.” – Warren Buffett
What am I paying for this deal? You have probably asked yourself before and you’ll probably ask yourself again.
Every investment comes with a price attached to it. You will have to give something to get something. Even if you are not putting in cash, but instead are asked for sweat equity, these rules still apply. If it’s cash, you want to pay the best price possible for whatever you are buying.
Some pricings are simpler to understand than others. For instance, you decide to invest in a rental property. Since it is located in some specific geographical area, you can simply check comparable sales to evaluate a reasonable price based on the income and condition of the property.
Low-risk investments, such as money market and savings accounts, are valued by the rate of interest they will pay you. You expect to get 100% of your principal back at a specified time, plus your interest. The value is based solely on the rate being paid. However, you should always check the health of the bank you are giving your money to in order to make sure they can be trusted to hold your funds and pay the interest. If a bank goes bankrupt, you could lose a substantial portion of your capital.
Your CDs and accounts are insured up to certain limits. You can get more data from the FDIC site: http://www.fdic.gov/deposit/deposits/insured/faq.html. On stocks that are publicly traded, there is a marketplace that also helps establish the price. That market can be very easily manipulated, which can inflate and deflate stock values regardless of the company's financial health. Just look at the wild gyrations of the market in the last twenty years. Up – crash – up – crash. Hard to stomach the ride sometimes.
Even with publicly traded stocks, you must do some homework and not just buy the sizzle. If it is publicly traded, there is usually information you can gather online about their current business, revenues, profits, etc. However, in the case of some smaller companies, there is very little information other than what the company itself provides you, even though they are publicly traded.
Some startup partnerships and small businesses offer you stock, or units, or a percentage of ownership for some price. Like $2.00 per share or 10% for $200,000. How do they arrive at that price?
Let’s take the $2.00 per share example on a small company. This seems like a reasonable price for a share in Company X based on what you have seen or been told. First, do the math. If the company has 5,000,000 shares outstanding at $2.00 per share, the company is valued at $10,000,000.
How do you know this is a fair price? Almost every investment I see is grossly overvalued. The value is very arbitrarily reached by the principals. They say, “we have all these patents and feel they are worth ‘X’” or, “we feel we will make huge profits as soon as ‘Y’ happens and that makes us worth ‘X’ today.” You have to look at the patents, at their financial projections, their market research, and their executives to see that it makes sense. In my experience, marketing and sales projections tend to be highly exaggerated. Everyone thinks the revenues will go straight up and the public is dying for their product or service. If that were true, then the last hundred business plans I looked at would all be thriving businesses with millions in profits.
Sadly, the truth is that maybe one out of a hundred is a reasonable success. Even Wall Street has thousands of sad stories about big, well-financed companies going bust after a few years. I do my own homework if I really like the story and think there is a real business. When I am done, if I think the company is worth $2M and not $10M, I will offer to buy in at my price. Take it or leave it.
Businesses are, generally speaking, either a going concern (that is somewhat established and producing products/services) or speculative. If they have been in business for a while, they may have already proved their product or service is needed and wanted and they are seeking additional capital to expand.
For example, one company I am involved with has recently had sales take off. One order from Amazon was for $1M worth of product. Great news! But Amazon needs the product in their warehouse before they will pay the invoice. The factory wants their money before they will ship to Amazon. So, they are raising money to finance delivery.
Another company is increasing revenues steadily but must add staff to keep up with the demands of services. Their revenues have been up four years in a row and are finally showing profits. They are raising money for a big push as well.
Another company I supported had a great idea but had never been sold before. So, after thorough market research on the perceived public, some seed money was raised because the response was favorable. This was highly speculative and not one person I spoke to was permitted to put in more than about 1-2% of their net worth.
All the above companies were priced fairly, in my opinion. However, as stats go up, the concept is proven, and profits are made, they will be priced higher for the next round of investors. Why? The risk has been reduced now that they are organized and making profits. Business has taken root. The longer it has been around and the better it is doing, the more expensive the investment.
Some of the greatest ideas I have heard were just not backed with enough skill, finance and drive to deliver the goods. It takes lots of hard work and persistence to make a viable, expanding business. Moreover, if it is not really driven by a desire to produce that particular product, it is doomed to failure. If he doesn’t love making widgets but just wants to sell them and make a million dollars, don’t bother. Because when it gets really tough, who do you think will stay on the job? The guy who really loves making widgets and knows everything about them. The people who just want to be rich are gone after the first serious thunder and lightning strike.
Good luck out there. Feel free to contact me if you ever need help.
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