Tuesday, August 08, 2006

Illiquid assets

Business Week inspired much yelping in the blogosphere this week with a splashy cover relying on some incredibly dodgy math. "How This Kid Made $60 Million in 18 Months," touts the cover ... glossing over the small detail that the profiled digg founder hasn't "made" any major cash money from the site and that the $60 million is a plucked-from-the-vapor calculation based on some unnamed sources' estimates of digg's worth. (The site currently claims $3 million a year in revenue. Mature companies generally get acquired for a single-digit multiple of their annual revenue. Early-stage ventures with very bright prospects go for higher multiples, but still, this is some impressively bubble-era math Business Week is doing.)

Plenty of others have kicked and dismantled this article in better detail than I can, but what caught my attention about the story from a personal-finance perspective is how nicely the flap over it illustrates the difficulty of valuing illiquid assets. Not many of us own potentially million-dollar Web companies, but almost all of us have assets that are valuable but not easily valued.

Homes are the most obvious case: a house is worth only and as much as a buyer will pay for it. What makes an apartment that sold for $200,000 in 2001 "worth" $400,000 today? Only the complex magic of supply, demand, and all the real-estate-ecosystem forces acting to influence them.

But houses, at least, have established guides for estimating value short of actually selling them, including appraisals and the constant data flow of nearby home sales. There are lots of assets we pick up with even more opaque financial valuations.

For me and David, the big financial X is our book collection. One of the items on my 'I really will deal with this ... eventually ...' list is getting renters' insurance. If our apartment flooded or burned down, one of our biggest financial hits would be writing off or replacing the 2,000 to 3,000 books we cohabitate with. (I'm slowing cataloguing the collection over at LibraryThing.) The overwhelming majority of our books are very standard, easy-to-find items that could be replaced for less than $5 over on Abebooks. Our "collection" is hardly the sort of thing Nicholas Basbanes will one day lovingly chronicle.

Still, hoovering books at the rate we do means you're bound to sweep up a few valuable ones, both intentionally and serendipitously. But attaching a "valuation" to books -- or any other collectable with a secondhand sales market but little intrinsic value -- is a tricky business.

I end up thinking of three separate "valuations" for our books. First, there's the dollar figure of what it would cost to replace them. If my copy of the Codex Seraphinianus were destroyed, I'd need to budget a few hundred dollars to re-buy a similar one. I could go through every book in our library, figure out a reasonable replacement cost to re-purchase the book, and assign a "value" to our collection that way.

But that value would have little relation to the dollar figure our collection would bring in if it were sold, either piecemeal or as a whole. Every bookseller knows that the retail price of a book is a significant markup over its wholesale cost. Bog common books that cost me $1 to buy on Abe would fetch me only pennies if I tried to sell my copy. For 95% of our collection, the replacement cost "valuation" would be significantly higher than the dollar amount for which the books could actually be sold.

Which leads to the third "valuation" for our collection: the wildly variable "value" of the handful of genuinely scarce items. Here, the value is directly dependent on how much time you have to seek a buyer. If we had a financial catastrophe and I needed cash immediately, I could eBay our Codex for $100 or so and get that price fairly quickly. But if I wanted to get top dollar for our copy, I could probably hold out and eventually get at least $350 (it's a very nice copy of an in-demand edition) for it from a dealer or another collector. So what's a more accurate valuation for the book: the 'liquid' value for which it is immediately sellable, or the harder-to-realize, higher price an appraiser or collectors' guide would assign to it?

This is all fairly academic, since I'm not planning to sell of our books or stress about an appraisal for insurance. I'm sure that if I really cared, there are formal answers for how to value things. I just find it intriguing to have a portion of my 'wealth' tied up in something that can't sensibly be given a fixed financial value.

And hey, my valuation challenges are minor compared to what art collectors must go through.