Mind the Gap: Bargain Hunting in a Cash Rich World Buying is fundamental to any investment's success. But what makes a good investment? Here are three things to look for when measuring the gap between the price you pay and the value you get.

By Ankit Kumar

Opinions expressed by Entrepreneur contributors are their own.

"Price is what you pay, value is what you get"– Ben Graham

Buying well is the most critical factor in any investment's success. When we buy well, there is a significant gap between the price we pay, and the fundamental value of the business to us. However, in an efficient market with many equally intelligent buyers vying for the same business, why would this gap exist?

Related: The Secret to Great Value Investing

One framework I have found useful to understanding this gap is this: the market clearing price of an asset is the fundamental value of the asset to us minus the value of truly unique value creation opportunities only we can access minus psychological and technical factors which impact other buyers or the seller.

Market Clearing Price = Fundamental Value – Unique Value Creation Opportunities – Psychological Factors – Technical Factors

Let us now examine more closely each of these three factors which drive the gap between fundamental value and price.

1. Unique value drivers

Related: The Power of Being Unique in Your Industry

Sometimes as buyers, we actually have the ability to increase the fundamental value of a business more than other potential buyers. There are typically three ways to achieve this. First, we might possess unique insights into the business which we can use to build a differentiated strategic plan and identify unique value creation initiatives. Second, we could also have unique execution abilities to drive key operational initiatives. Third, we may be able to take advantage of synergies with our other existing investments.

A few years ago, we made an investment in a fire-sprinkler components manufacturer. This is a niche duopoly market with our company and a division of a fortune 500 company splitting the market in half. While pursuing this investment, we were the only potential buyer working with the former division leader of a Fortune 500 company. As a result we had unique insights into the competitive dynamics and key value creation levers. One short term value creation lever was strategically increasing the prices of our products. We were able to underwrite and execute this initiative because we had insights into which SKUs were truly unique and where we had more competition. This allowed us to take a higher price increase on the former and a lower one on the latter. Another key initiative was to enter the large and high growth Chinese market. Since our executive partner had previously executed the China expansion strategy for our competitor, we were able to learn from his experience and expand into China. His experience enabled us to develop the strategy, find a local management team, and find customer and supplier partners within China, thus turning into reality an initiative that might have otherwise just sounded good on paper.

2. Psychological factors

Related: Many People Are Burdened by Fear. Here's How I Embrace It.

Psychological factors can be those that impact other buyers or those that impact the seller, and can lead to very attractive buying opportunities. Excess fear, self-doubt, and desire to conform to the herd mentality are strong psychological factors which can drive gaps between value and price. Complex situations, which are not well understood, and unloved sectors or businesses can also result in such excess fear.

For example, we invested in a company which was the unrivaled leader in safety consulting services for commercial buildings. The company had a great brand, a pool of talented and hard to find engineers, and was the leader in a high-growth recession-resistant category. However, the company had also been built up by acquiring six smaller businesses which operated different information systems. Further, the office of the CFO was very poorly run. As a result, it became apparent during due diligence that it was extremely hard to get high confidence in the precise earnings of the company. This created fear among potential buyers and reduced the competitiveness of the auction process. As a result, we were offered the opportunity to acquire the business at 10x EBITDA when comparable transactions had been done at 12x-14x EBITDA. By doing the hard work to understand the earnings trajectory of the business, we were able to box our risk and get confidence that the earnings were within 10% of the company's stated number. This was a great example of an extraordinary business franchise with a localized and fixable problem trading at a deep discount due to excessive fear in market participants.

There are other psychological factors that may come into play. In some situations, the seller is emotionally attached to his business and cares about who he sells to as much as the price; for example, a founder who desires to retire, but does not have a succession plan and is very cognizant of her legacy. In other situations, such as strategic divestitures, the seller is more concerned about the speed and ease of selling the asset and less on getting the last dollar in price. These psychology driven special situations provide attractive investment opportunities by creating a gap between clearing price and intrinsic value.

3. Technical factors

Some examples of technical factors that can result in attractive prices include: a forced sale when a highly leveraged business hits a short-term road bump close to a near-term debt maturity, divestiture of a business division forced by antitrust regulators and stocks falling out of an index or debt ratings downgrades which drive investors out of these securities because of institutional mandates.

For example, Berkshire Hathaway invested $5 billion in Goldman Sachs in September 2008. This was soon after Lehman had declared bankruptcy and the credit markets had frozen. In return for the investment, Berkshire received preferred stock with a 10% cash dividend, a 10% premium payment if Goldman redeemed the shares, and a five year option to buy another $5 billion of shares of Goldman Sachs at a price of $115 per share. As a result, Berkshire received $1.3 billion in cash dividends, $500 million in redemption premium, and $5 billion in stock price appreciation which turned the $5 billion invested into approximately $12 billion.

By keeping the above three factors in mind and diligently asking ourselves which one of them is driving the gap between price and value, we can make consistently successful investment decisions and avoid the pitfalls of overpaying for investments we like.

Ankit Kumar

Entrepreneur Leadership Network® Contributor

Private Equity Investor

Ankit Kumar is an investor and builder of high-growth businesses. He is an accomplished private-equity investor with experience investing in technology and services businesses across the U.S. and Asia. He is especially passionate about building fintech companies.

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