My six-and-a-half-year-old son was busy building a Lego creation of sorts when he tried to tell me the cost of what he was making.
“What comes after a million?” he asked. I replied: “A billion.”
He then said: “Oh yes, the price of this [his latest creation] is five billion,” adding that the “chompy” he made earlier was worth four thousand.
Two friends of his, he said, wanted to buy his “chompy”. But he had decided to sell it to his friend, who had fewer Lego pieces, at the price of four thousand. And if he did not get it, he would not sell.
I have no idea what the currency or unit of payment could possibly be, but I was struck by the idea that this little person had made a decision regarding the value of something.
He had decided that a piece he had created – that he was very attached to and loved – was worth something very specific. To him, at least.
Whether he would ever find a buyer at the price he had set is another thing entirely.
This is what valuation is: an emotional, complex process. Whereas pricing is based on time-based comparisons, which in the case of pricing the “chompy” would mean the cost of the Lego pieces plus the value of the amount of time spent creating it.
This incident occurred a day after I listened to an analyst talk about much-anticipated launch of Twitter’s public share offering, a day before the listing. The analyst talked about valuations and how they come about.
This expert said one way of doing this was to think in terms of buying a house. For example, you would look at other houses in the neighbourhood and see where the one you want fits in, and get a feel for whether the asking price, or the valuation, is reasonable.
The analyst’s overall message was that Twitter’s shares were being priced by comparing them to those of its peers – companies such as Facebook, which was making money when it launched its initial public offering in 2012. Twitter, on the other hand, has been losing money.
The long and short of it is that the analyst believed that Twitter was overvalued at its asking price of US$26 a share. The interesting point for me was looking at valuation versus pricing, and how they come about.
Let’s go back to the example of buying a house:
The right pricing for you depends on your comparison of what you want with prices of other similar properties.
The valuation is different. It includes how much you think a property is worth to you. This could be because of the layout, the way it looks, or some other distinctive feature, or anything of importance to you such as its location. Other considerations include how far it is from your workplace or your children’s school. You are more likely to accept paying a higher price for a property that is of great value to you and your lifestyle.
Meanwhile, a friend said she made an offer for a set of second-hand curtains she saw. Her offer was not based on their value but on what she could afford.
She did not think she would be getting those curtains because the seller wanted a higher price.
So my friend has to shop for less expensive curtains, and the seller of the curtains she wanted has to wait, or hope, for a higher offer.
But who knows? If the seller does not get a better offer by a certain time, my friend might have them hanging in her home, and she would have kept to her budget.
The bottom line is that any asset is only worth what a buyer is willing to pay for it.
And what we’re willing to pay needs to factor in what we can afford, not just how much we want or need it.
Remember, your next big must-have item will be superceded and its value eroded with your circumstances and changing priorities.
We have all bought a “chompy” or two in our lifetimes, but resist those emotional temptations, or else it might be curtains for your financial wellbeing.
Nima Abu Wardeh is the founder of the personal finance website www.cashy.me. You can contact her at firstname.lastname@example.org