The Value Equation, by Ewan Pearson

In Berkshire Hathaway’s 2008 letter shareholders, Warren Buffet wrote: Ben Graham taught me that “Price is what you pay. Value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.1

Being a Scot, I too like buying quality at low prices, and I like his rhyme, but beg to disagree with Ben Graham. This is a radical suggestion as Ben Graham is considered to be ‘the father of value investing’, writing books on this, and teaching at Columbia Business School. You see, I think the quote should be ‘Price is what you pay and good value is what you hope to get’. Why do I take such a contra view? Because when you buy something you often don’t know whether it will be any good or not. So you are in part taking the advertising, brand and sales pitch on trust. It is only when you unpack the goodies, be they a product or a service, that you find out whether you were sold a dud or not. You are therefore irrationally relying on belief, trust or hope. “We’re the best; trust us”.

The topic of Value for Money (VfM) has come up a lot in our recent client work, be it a firm pitching for business, be it an audit mandate, a company to float, or a fund seeking investment. All are “selling the dream” – that what is for sale is good value. It turns out that we humans are not good at discerning VfM, especially for things we have not yet tried out; that is where any statement about the future lies. “Our fund/shares/staff will outperform” (delete as relevant) is a common theme, even if the FSA does not allow it to be stated boldly, if at all.

So buyers use what they can. They often use price as a proxy for value, especially when we cannot discern value easily. This has been found for example with wine, pain killers and perfume in the world of products, and with investment banking and private equity in the financial services world. On a more sophisticated level, buyers include an assessment, often subjective, of quality.

From this at GPB we have derived a simple equation, the Value Equation: V = Q/P  wheere V is ‘Value for Money’ (VfM), Q is Quality, and P is Price.

If you have a think about this equation, you will see that what people really do is to compare quality with price, to try to get the optimal ratio, the maximum value for money.

Think for a moment though about these phrases: “Cheap as chips”, “Reassuringly expensive”, and “Never knowingly Undersold”, and you realise that actually ‘cheap’ can mean bad as often as it means good, and likewise for ‘expensive’. In America, a huge generalisation would be that the more you charge the better value you must be, in Australia, I’ve found it largely worked the other way round, and in Europe we seem to be somewhere in the middle. It all seems very confusing!

In the EU’s tendering process, VfM is called M.E.A.T, which stands for Most Economically Advantageous Tender. It is even formalised, with typical public sector and other OJEU* tenders including both empirical scoring criteria, such as ‘Deliverability’, ‘Availability’, ‘Quality’ and in a separate category, ‘Price’.

Here is a recent example:   Quality 25%         Roll-out 15%        Premises 15%       Price 45%.

The method used to calculate the winning tender is simple: The cheapest provider is given 100% on Price, with the others rated as a % of that, so if you are 25% more costly, you score 100/125 or 80%.

 The same is done for the other metrics, often with highly elaborate breakdowns of marks, that can go up to 600 in total. There is an illusion of measurability in all of this, which is pretty scary for some suppliers, although often it is not hard to see how to get (and lose) the marks. Then the scores for V and P are compared with the best ratio winning the tender. 

Our equation comes in very handy when advising clients at pitches who are concerned that they are ‘too expensive’. We ask them to look at the likely price premium, and compare that with their quality premium. Often clients think it is enough to be (say) 25% better in both. Unfortunately this just makes then the same value for money as a provider 25% cheaper with quality 25% worse. V=Q/P shows this up very simply. We instead ask that the value difference exceeds the price difference so that the comparison favours our team, thus:

Example A: (Lowest cost provider)         Quality = 1, Price = 1,          Therefore V = 1.

Example B: (Our client)                            Quality = 1.5, Price = 1.25   Therefore V= 1.2.

The burden of proof now rests with our clients to show in a compelling way that Q = 1.2x the value of the lowest costprovider, as the rest is just numbers. This is not easy, but at least it focuses on what is important, value vs. price. All of the above is just an elaborate way of saying that we all want best value. But it is a good way of broadening out the thinking beyond an anxiety over having a slightly higher price, and instead putting the focus on value. Or to paraphrase what one client of ours says, “the most expensive product or service is the one that doesn’t work”.  There has been some recent research at Yale University2 into the behaviours of monkeys in value trials. Although they are mostly just as irrational as we humans, when it came to value experiments, they don’t fall for the old ‘it costs more so it must be better routine’. They did not   assume as much as humans do that higher prices means better quality and instead should a high degree of rational behaviour.

So, I guess the question to you should be: Are you Man or Monkey?

By Ewan Pearson

*OJEU: Official Journal of the European Union 

Sources:

1 Berkshire Hathaway 2008 letter to shareholders, page 5.  2 Yale University study: Capuchin monkeys do not show human-like pricing effects; Frontiers in Psychology, November 2014 .

 


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