There is a certain predictability and orderliness to the prices of products and services. From bananas to gasoline to wages and even real estate, prices derive from supply, demand, and competition.
Of course, pricing strategy is infinitely more complex than that equation sounds, which is why MIT Sloan Executive Education has a live, online course dedicated to the topic. And while price is one thing, value—or worth—is quite another. The semantics of these terms alone is complicated (“value” and “worth” have specialized meanings in economics, business, and philosophy). In accounting and finance, value and worth are often used interchangeably and considered equivalent to an expected sale price. But as you might have guessed from the title of this blog post, it’s not that simple.
What is the fair market value of an object that cannot be sold?
In his short course, Fundamentals of Finance for the Technical Executive, MIT Sloan Lecturer Paul Mende can relate to the participants in the room. A former technical executive himself (as well as a theoretical physicist), he learned the principles of accounting and financial decision making on the job. “I enjoy showing participants the greatest hits of finance,” he says. “And we have fun with it.”
One of the concepts Mende tackles early in his program is that of fair market vs historical cost accounting. For the past two decades, fair market (or fair value) accounting has been on the ascent. The practice of measuring assets and liabilities at estimates of their current value, this accounting basis is a departure from the centuries-old tradition of keeping books at historical cost.
“But here’s where it gets complicated when you’re trying to manage a business,” says Mende. “In the financial world, something is worth what people are willing to pay for it—fair market value. But the way you base forward-looking decisions for running a business is tied to neither fair market or historical accounting basis. Value is central to finance, but there isn’t a single definition of it. So, it’s not a fight of which is right—each is just used in a different way.”
In his Executive Education program, Mende ups the ante on this discourse by asking, “What about something that can’t actually be sold?” He points to the famous conundrum that rocked the art world back in 2012, when the IRS came calling on the owners of Robert Rauschenberg’s Canyon. This masterwork of 20th-century art is one of Rauschenberg’s hybrid works incorporating painting, collage, and found objects. Included in Canyon is a stuffed bald eagle that had been previously found in a pile of debris and given to the artist by a friend. The work ended up in the estate of New York art dealer Ileana Sonnabend, a collection worth billions of dollars and inherited by her children upon her death in 2007.
According to the U.S. Internal Revenue Service, the work was subject to an estate tax based on its market value. However, bald eagles are under federal protection, therefore making it illegal for the heirs of the estate to sell it. Because the work couldn’t legally enter the marketplace, three independent appraisers hired by the estate valued the work at zero.
“Of course, the IRS had a different view,” says Mende. They convened their own Art Advisory Panel, which appraised the work at $65 million (after having previously valued it at $15 million). “The numbers were all over the place.” The panel claimed their valuation took into account the sale price of comparable works sold at public or private sales. (An article in Forbes noted that the IRS hypothesized that an art lover in another country, like China, might be willing to buy and hide the work, therefore making it worth something.)
The resolution they eventually reached allowed the family to donate the work to a U.S. institution in exchange for dropping the tax claim. Thus, in 2012, Canyon was donated to The Museum of Modern Art (where the work had been on view). Nonetheless, the controversy proves that establishing value is sometimes an art form unto itself.
The tooth fairy index
Valuing unique works of art may be complicated, but what about something more mundane?
In 2014, during Obama’s second term, members of his economic team were preparing to meet. Among them was Betsy Stevenson, whose child had just lost her first tooth. As team members began to settle around the table, she took advantage of the collective intelligence in the room and asked, “What’s the tooth fairy paying these days?”. As a kid, Stevenson, like many of us, got 50 cents. The room full of top economists were able to immediately adjust this for inflation and determined that, by this measure alone, the tooth would be worth $3. “But what are your kids actually getting?” she asked. The answers were anywhere from $5-20 dollars. (You can get the full story on NPR.com.)
It turns out there is real data out there to answer Stevenson’s question. Delta Dental has been conducting a tooth fairy poll since 1998; the average going rate for a lost tooth is currently $4.66. The tooth fairy has outpaced inflation by a long lead—10% compared to 2%.
One phenomenon to explain such an anomaly: income elasticity of demand. Let’s say you get a 10% raise. It’s very unlikely you’ll start spending 10% more on every aspect of your life. But there are categories of things where you will—and who doesn’t love spending more money on their kids? In the case of the tooth fairy, value is entirely discretionary.
Did Amazon pay too much for Whole Foods?
While it’s unlikely that anyone is losing sleep over a $5 tooth expenditure, some investors are indeed tossing and turning over a recent, much larger purchase. Amazon announced in June that it’s buying Whole Foods for just under $14 billion, the retailer’s largest acquisition ever. As Derek Thompson wrote in an article for The Atlantic, “The purchase holds implications for the future of groceries, the entire food industry, and—as hyperbolic as this might sound—the future of shopping for just about anything.”
The deal values Whole Food at $42 a share, 27% higher than where the stock was trading the day the deal was announced. To Jeff Bezos, now the second richest man in the world, the value of Whole Foods is worth significantly more than its market cap would imply.
At the simplest level, the deal represents a straightforward confluence of interests. Amazon needs food and urban real estate, and Whole Foods needs help. Amazon is interested in building out its food delivery service play. Amazon also needs a distribution hub for that service.
“Amazon did not just buy Whole Foods grocery stores. It bought 431 upper-income, prime-location distribution nodes for everything it does,” tweeted Dennis Berman, the Wall Street Journal’s financial editor.
More than just distribution, Amazon, like other e-commerce retailers, knows there is value in brick and mortar; physical stores can play a critical role in an omni-channel retail strategy. Bonobos, the largest clothing store ever built on the web, is optimizing both an online and in-store experience for men's clothing; they recently opened showrooms that provide customers with one-on-one service including size and style advice. Warby Parker started as an online-only retailer of prescription eyewear and has since mastered the store experience, now operating close to 50 locations that enable customers to try on frames.
Certainly, when it comes to groceries, many shoppers prefer to see, touch, and select their own produce. But Amazon’s latest purchase is also part of their overall, “life-bundle” strategy, particularly for affluent Americans. While other giants like Costco and WalMart have said that online grocery delivery is a nearly impossible business, if anyone can make it work, it’s probably Amazon.
If you’re interesting in learning more about managerial accounting, financial concepts, or pricing strategies, learn more about these MIT Sloan Executive Education programs: Fundamentals of Finance for the Technical Executive; Strategic Cost Analysis for Managers; and Pricing 4Dx (live online).