Value is the worth we assign to things. It could be a commodity, a service, an asset or even a company. Things have intrinsic or bestowed utility. What we do when we value them is we define the monetary worth of that utility to us. Therefore value differs from place to place, from person to person and also from purpose to purpose. To say that something is more valuable than another is to say that we (group of like minded people) see its potential in generating higher benefit to us as compared to another thing meant for similar purpose.
Why should the price reflect value? Simply because we need a yardstick. Anything which is taken to market for trade needs to have a tag (or at least an initial estimate) of price to moderate forces of demand and supply. If not it becomes difficult to find two sets of people namely the buyers and the sellers. The buyers want to exchange value for price and the sellers want to exchange price for value.
So, in valuing companies there are some accepted methods. Some people believe that value of a company should represent present value of future net cash flows it is likely to generate. Some say that value depends on present worth of its net assets in use as on today. This school of thought does not like to look ahead into the unknown future and arrive at present value. Then there are those who feel that value is a relative term. We need to value companies on relative basis. So, these folks look at similar companies and adjust the value for the company under consideration accordingly. Some also look at ‘options’ available to the company and try to estimate the value of the company using option pricing models.
Well, whichever method is used, it is necessary to understand that there is no one right answer. There is nothing like ‘correct’ value. Valuation is an abstract phenomena. When I look at a classic painting, I seldom get convinced about how on earth can someone pay millions of dollars to possess the thing. But that’s my ignorance. I know nothing about art. If a bunch of clueless guys like me sit together to decide value of a rare work of art, we would end up grossly disappointing a connoisseur of art works. Opposite might also be true though. People who don’t quite understand something might overvalue it. They may get excited to pay a price that the thing does not deserve. But again it is a personal choice. This choice stems from Herbert Simon’s ‘bounded rationality’. We see what we want to see. We get what we want to get. Profit or loss is thus our making inside our own heads.