Two well established concepts in modern economics and finance are economic value and market value, and these are important factors in the model of a company’s future potential growth (and its share price’s future). Yet these concepts are often confused, with economic value often being ignored entirely.
Let’s start with market value—a simple idea, namely that there is a price where buyers and sellers meet to make a trade. For instance, let’s say there is a single baker in a town; as he is the only source of bread in the town, he can sell it at any price he wants, so he abuses this monopoly position to charge a high price for bread. Then a second baker comes into town and sells bread at a much lower price—but still at a quite high price for the market. Market competition compels the first baker to lower his prices to undercut the second, who will then lower to undercut the first—and so on, until the two reach similar price levels where the two are still profitable, but the profit margins are at the lowest point possible. When this happens, bread has achieved its market price.
(This example ignores a lot of things like monopsony, cartels, price fixing, and so on—it’s usually much messier in reality! But you get the point.)
Economic value is a bit different. Now let’s imagine the two bakers are selling at the market price, and a marketing genius comes into town and meets with one of them. “I can get you a higher price than what you’re currently selling by telling people this bread is superior to all other bread,” he says. Then he asks the crucial question: “what’s the most people will be willing to spend for your bread?” The answer to that question, then, would be the economic value.
In other words, market value is where markets clear and buyers and sellers, working competitively, agree on a minimum price where the sellers can keep producing and the buyers are willing to buy; it works when the consumer has maximum power in markets. Of course, that’s rarely the case; thanks to regulations and large scale competition, many markets lack the monopolies and antitrust practices that would lower their power, but there are still many opaque markets—some of which are caused by poor regulations or informational asymmetry. In this situation, the seller has more power and can get the clearing price of the product closer to the economic value.
One way to think of this is that the ideal buyer (i.e. one who acts in the most rational and well-informed way possible) will always try to get the good at the market value, while the ideal seller will always try to give the good at the economic value. Auctions, exchanges, and markets are where this tug of war between the two constantly plays out.
Why does this matter for analysts? One way to think of future sales of a company is whether the current price of a good is at its market or economic value, and what a company can do to bring it closer to economic value. Companies that can do so can easily increase margins without sacrificing volume—but admittedly those opportunities are rare. Which is why understanding the concepts and knowing when to employ them is crucial.