Relative Value v. Absolute Value
I have been reading a book called Predictably Irrational by Dan Ariely which has raised some thoughts I’ve had for awhile about why human nature tends to define value on a relative basis rather than on an absolute basis. The first time I started thinking about this was when I would ask friends to pick which scenario they’d prefer:
- You make $80,000 in a world where everyone else makes $50,000.
- You make $90,000 in a world where everyone else makes $150,000.
Most people I asked that question to, after thinking about it, preferred scenario #1 despite making more absolute money in scenario #2. It shows that in this instance, they value relative wealth over absolute wealth. It’s clearly an imperfect example because it’s too theoretical, but it does start to uncover the issue at hand. Let’s take a more practical example – imagine you had to rate the “value” of the fish and chips on the following two menus:
- Fish and Chips: $15, Grilled Chicken: $7
- Grilled Chicken: $29, Fish and Chips: $15
My guess is if you conducted a study, the fish and chips on the second menu would be rated as a better value than the fish and chips on the first menu – despite the same absolute price. While not using this example, Predictably Irrational does leverage compelling studies that show that a highly effective technique to sell a given product at a given price is to put another product at a higher price right next to it. Again, this plays to our sense of relative value. Another example – imagine you had to rate the attractiveness of the second person in each scenario:
1.
2.
Somehow I think the results would show a higher rating for the middle picture in the second scenario than the first. In fact, Predictably Irrational talks (semi-seriously) about how if you’re going to a bar – the best advice they have to optimize your personal attractiveness is to make sure your wingman is slightly less attractive than you. OK, one more example, and then I will in fact relate this to the venture world and technology. This one is from the book – imagine you had to select in both cases whether you would make the drive:
- Drive 10 minutes to save $5 on a $15 pen.
- Drive 10 minutes to save $5 on a $500 suit.
Despite the same absolute economic savings and same cost (driving 10 minutes), a substantially higher percentage of people would make the drive in scenario 1 rather than scenario 2, because of its higher relative value. You get the drift.
OK, this dynamic does in fact play out in the venture world more often than one might expect. I’ve seen it in many different instances, but most classically during an acquisition process. Consider how supportive you would be of taking the deal in the following two scenarios:
- You have a $20M revenue software company. An acquirer comes along and offers you $20M and says you are worth 1x revenues. Then through your shrewd negotiating and creation of a bidding war, you’re able to walk up the price offered by that acquirer up to $100M. You have increased their offer by 5 times!
- You have a $20M revenue software company. An acquirer comes along and deems the company strategic and offers you $200M. But, then through the diligence process they uncover some issues and decide your company is “only” worth $100M – an insulting 50% less than their original offer.
In my experience, despite the same absolute value at the end, boards would more likely be celebrating in scenario 1 and angrily walking away in scenario 2. Why? Again, it’s all about the relative value against the starting bid.
While I’m not trying to make relative value seem irrational (because I don’t think it is) – it’s worthwhile to recognize how human nature can sometimes inappropriately define value exclusively on a relative basis to the neglect of all other reasoning. Perhaps we need to learn how to put aside our need to compare, and just be happy with what we’ve got. In an orthogonal way, this reminds me of a quote I heard years ago, “Being rich is not about how much you have (or how much more you have), but it’s about how content you are with what you have.”
Thinking About Thinking 
This one was particular thought provoking — potently kicked into my cerebral side….hope you don’t mind — I posted it to my facebook “share.”
Absolutely – appreciate that. Hope all is well Sun.
I agree that we should be content with what we have. However, imagine a world that everyone’s happy with what they have, there will be no trades, no commerce, no competitions, no growths and etc. The fact is we will never be content/satisfied. This is our human nature.
Hey big daddy – great name. You must be really big. And also a daddy. Ha ha. I hear what you’re saying. That’s why I think there is merit in relative value, but in a balanced way.
So do we teach our kids that it’s not about winning – or it is about winning?!
Ah, but if *everyone* else makes $50,000, the cost of living would be proportionately lower, no?
See, it’s really a trick econ question. Relative value FTW.
Ah yes – I forgot to put in the “all things being equal” trump card. But, I didn’t so, would the cost of living be proportionally lower? Depends on income taxes :).
[…] Cheng har en interessant post på bloggen sin om hvordan vi definerer verdi på en relativ […]
Larry, i concur. very thought provoking piece. i am a researcher (private equity, econ, finance, etc.) as well as a yoga teacher and the idea of a person’s (or any being’s) intrinsic absolute value is a big theme for me. we always compare and wish we had what we haven’t got instead of realizing that we already have everything we need. when we start from this place of recognizing our absolute value/worthiness, we can progress. when we start from a place of wishful thinking, we fall into a trap which leaves us feeling unsatisfied and wanting more… thank you. so it is a the idea of lack, void, dearth vs. abundance.
Anna – cool that such a concept can make its way into Yoga. I think there is a lot to be said about how all of this relates to self esteem and satisfaction.
Great post. I would even argue that absolute value very rarely exists in the venture world. From the venture investor perspective, when was the last you used 100% factual based valuation to begin with vs. place a point of reference (exit value of successful company in the same market, another deal you know of, another similar company that got close to the deal closing but never happened, etc.)?
Chris, I think a fact based (or absolute value) valuation would be some sort of DCF where you’re valuing a company based purely on what it can generate. A comps analysis is inherently a relative value analysis. Clearly, VCs use comps far more. We even use the most arbitrary of comps which sometimes is the last round valuation – as though that has something to do with the current value of the company. It applies in so many ways.
Fun post Larry.
Its interesting you juxtaposed the salary hypothetical with the venture example. Now that you do, I see how they are related, although I think there are some differences.
In the salary hypothetical, the relativity is vis-a-vis co-workers and I think that taps into our desires to “keep up with the joneses” — that happiness is one’s success relative to one’s perceived peer group. I tend to view this as a social pressure of sorts.
The venture example I tend to view more as an anchoring phenomenon — your happiness or unhappiness is dependent on your expectations on the “true” value of an item (in this case, the company). I always thought of that as less of a social pressure issue but a way in which our brain tends to be affected by data in ways that are not always logical.
oh, this is steve c, formerly of boston.
Steve – I agree with you. The two examples play off slightly different principals under the same larger umbrella of relative value.
Larry,
Totally agree here. I think it goes back to human nature and anchoring. It feels a lot nicer going from $5,000 to $100,000 in your stock account vs. 5,000 to $500,000 to $100,000 even though you end up in the same spot.
In your last example, it’s the classic case. The final destination is the same, it’s just the route traveled. Great post to think about. Thanks.
That’s a great example Timothy. A really great one in fact. Anchoring plays a role in so many different things it’s a little scary. We’re not really that rational.
This is why Investment Bankers are not worth using – they all use the same logic, math and approach … not value.
All companies are not homogeneous and in a sector equal to some contrived going rate EBITDA multiple.
Dave – well investment bankers can create competition around deals which can drive up valuation (sometimes). It plays off the same principal – if another party is interested and willing to pay more then you may be more inclined to think the company is worth more also. If we just valued the company absolutely, we’d say it’s worth $x and that’s it. Whether someone else was interested in the company or not wouldn’t make a difference. But, that’s not really how it works most of the times.
Somehow I think this only applies to those who have more, because I have the impression they are the ones who are striving to have more. It’s the basic logic of the rich wanting to be richer.
If you belong to a group of underprivileged people, 1,000 is 1,000 and it wouldn’t matter much whether the people not in their group earn 100,000 or 10. All that matters is they have something enough to spend for their needs.
Diverting to non-societal-issue aspect of it, I guess whether we earn more or less than another group and how we feel about it is affected by two things: the yearning to have more (need I say human nature?) and the need to feel more valuable. I guess both are self-explanatory so I’ll leave it at that and make my response short for once. lol
-Adriaan
[…] Value vs. Absolute Value of PLM I was reading an amazing post by Larry Cheng: Relative Value v. Absolute Value. This made me think about how we are developing PLM today. It seems like we are doing this with […]
yea, this still make confuse about when relative or absolute, but thanks that I know your opinion about this.
I just started taking an econ class this week and was asked about the Relative v. Absolute size of the U.S. economy. This post got me thinking in some new ways. Thank you.
Great article!
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Great mix-tape. It’s getting played to death these past few days.
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Hahaha well said! I agree completely!
[…] is a unit of account: Humans are hardwired to think in relative terms. As a result, having money as your standard yardstick helps you easily compare prices and […]
[…] is a unit of account: Humans are hardwired to think in relative terms. As a result, having money as your standard yardstick helps you easily compare prices and […]
Great post Larry – I’d like to reference and maybe use a few quotes in my blog if that’s ok?
https://davebrowettagile.wordpress.com/
Thanks,
Dave
Loved reading thiis thank you