Italian artist Salvatore Garau made headlines last week with the reported sale of his invisible sculpture at an auction. It is probably not our place to wade into heady debates surrounding the ontology of art, but the reported winning bid of $18,000 is admittedly hard to evaluate relative to something which, in at least a material sense, does not exist. Nonetheless, the sculpture did come with instructions for its proper display.
Mr. Garau’s innovation is in some ways the perfect embodiment of several valuation-related stories over the past year or so.
- Cryptocurrencies have been garnering headlines for several years, but the rise to prominence of Dogecoin during 2021 has been noteworthy, with spectacular daily price volatility and a year-to-day (as of June 7, 2021) return of over 7,500%. While other cryptocurrencies stress limited supply as support for value, Dogecoin eschews supply limitations and is described as "intentionally abundant" with a reported 10,000 new coins mined every minute.
- Interest in so-called meme stocks has ballooned in 2021, with retail investors buying shares in companies with less-than-inspiring fundamental stories in an effort to squeeze short sellers. While buyers of GameStop (up approximately 1,500% year-to-date) and AMC (capital appreciation of over 2,500% year-to-date) have certainly made shorting those stocks unprofitable, it remains to be seen whether the shares can hold onto current valuations over the long-term.
- NFT’s or non-fungible tokens blur the line between cryptocurrencies and real assets. NFTs are digital assets that represent ownership rights to digital artwork, highlight clips, music or the like. Unlike units of a cryptocurrency, NFTs are unique (hence the "non-fungible" element of the name). At the extreme end of the market, digital artist Beeple sold an NFT through Christie’s for $69.3 million. Despite not owning the NFT, you can view it here.
What does the well-publicized market activity for cryptocurrencies, meme stocks, and NFTs suggest for the value of your family business?
Valuation specialists like to distinguish between "price" and "intrinsic value." Prices can be observed in transactions; intrinsic values cannot. For some asset classes, there is no meaningful difference between the two notions. For example, individual investors in the U.S. treasury market are essentially price takers, so attempting to distinguish between price and intrinsic value doesn’t make much sense. Intrinsic value generally relies on a belief that there is a "fair" rate of return on an asset and it hard to argue that the "fair" rate of return on treasuries is anything other than the prevailing yield in the market.
When we move to the market for publicly traded shares, there are two dominant schools of thought. The first argues that public stock markets are efficient enough that any differences between price and intrinsic value do not persist long enough for investors to reliably profit from them. The logical conclusion from this belief is that one should invest in passively managed vehicles (index funds and the like). Active managers, in contrast, believe that they can successfully identify instances in which price and intrinsic value diverge.
We suspect that as one moves into more esoteric asset classes like crypto, meme stocks, and NFTs, the wild observed price volatility reflects the higher degree of difficulty associated with estimating intrinsic value. Investor returns come from cash flow yield and capital appreciation. When cash flow yield is negligible or not expected, value depends on expected future exit prices. Is GameStop a good investment at $280 per share? It is if you can sell it for $300 per share next week. If you can’t find that next buyer, it may prove to be a bad entry price for a long-term hold.
Where do family businesses fit in to this picture? The sort of "momentum" investing that powers market moves in crypto and meme stocks depends on liquidity: an investor can buy today and sell tomorrow if his mood changes. This same liquidity does not exist for family businesses, much less for minority shares in them. As a result, when you are thinking about the value of your family business, it’s probably best to turn off CNBC and think about three fundamental factors:
- Cash flow. How much cash flow does your family business generate after necessary reinvestments to sustain operations?
- Risk. How does the risk of your family business compare to that of other investments? By other investments, we don’t mean crypto or NFTs, we mean alternative investments of broadly comparable risk. The market for those assets determines the return required by potential investors: the higher the risk, the lower the value.
- Growth. What opportunities are available to sustainably grow the cash flows generated by your family business over time? Higher expected growth rates result in higher values.
The sale of Mr. Garau’s sculpture is a "man bites dog" sort of story and therefore generates a lot of headlines. For better or worse, the value of your family business is much more of a "dog bites man" story. Our advice is to ignore the headlines and keep focusing on the fundamentals: cash flow, risk, and growth.
