What is the purpose of a company?

A company exists to create value for its customers, and to capture some share of the value it creates.

This premise is simple to state, but it’s worth digging into some of the underlying concepts such as value creation and value capture.

What is Value Creation?

What is Value?

First of all, what is

? ‘Value’ is used in lots of different senses, in lots of different contexts, both formally and informally. For the purposes of this article, let’s consider

in the context of a simple transaction where you purchase a product in exchange for money.

Even in this simple context, there are still 2 distinct concepts that can be referred to as value[1]:

1. The price you pay for the product - let’s call this the

   exchange value

2. The total utility the product provides to you - let’s call this the

   use value

The difference between

and

is what economists refer to as

, and is essentially the difference between the price which a customer would be willing to pay, and the price that they actually pay.

The

of a product is necessarily subjective, and is assessed by a buyer at the time of purchase. On the other hand, the

of a product can be objectively observed during a transaction.

These 2 distinct concepts are what Ben Graham was referring to in his famous quote[2]:

“Price is what you pay. Value is what you get.”

In this case,

is what you pay,

is what you get.

Value Creation

What then, is

? In a sense, new

is always created with the production of any product. However, it may be that the new

created is less than the

paid for the inputs, and so it’s difficult to argue that a company has “created value” in this case.

Let’s provide a stricter definition that

involves creating more

for customers than the company pays in

for its inputs (including labour). The total amount of value created by a company is equal to the sum of all

it produces over and above the sum costs of the inputs it consumes.

Two implications should be obvious from this definition:

1. It is not practically possible to measure the true value a company creates

2. A company is unlikely to capture all of the value it creates

What is Value Capture?

The value a company captures is equal to the sum of the

a company charges when selling its products minus the

the company pays for its inputs. This is precisely (and not accidentally) equivalent to the concept of profit.

It’s entirely possible to create huge amounts of value and capture none of it, for instance, by creating something with high utility that can be reproduced at zero cost and then giving it away. Git, is a great example of this, and more generally the whole of open source software embodies this spirit.

Conversely, some companies are able to capture much more of the value they create than others. This arises for 2 reasons: (1) the level of competition/substitutability of the products (i.e. the pricing power of the company), (2) the pricing model.

Auction type pricing models are very effective at capturing large shares of the value created. In essence, auctions involve each prospective buyer placing a bid up to their

of the product, and the highest bid wins. If the

of the product is reasonably similar between prospective buyers then the marginal difference between the winning bid and the second bid will be negligible, and the seller will have captured almost all of the value created.

Google and Facebook are great businesses because they have created an oligopoly for our attention, and so have created a huge amount of value for advertisers seeking to acquire our attention. As they have a near oligopoly, there is limited substitutability for their product (attention from a specifically relevant cohort of users), and because of the nature of the product, they are able to run recurring instantaneous auctions to sell individual ad placements to the highest bidder. This ensures that they are able to capture most of the value that they create. Amazon has caught onto this idea, and rumour has it that Amazon now earns more from selling ads than it does from AWS[3].

Value Extraction & Value Transfer

Value extraction occurs when the actual

of a product is consistently less than the perceived

, and in fact is less than the

paid. In this case, value is not created, but

from the pockets of the buyer, to the pockets of the seller.

Stock market bubbles (or asset bubbles generally) are great examples of value transfer rather than value creation. During a bubble, some asset holders become notional “paper” millionaires as the valuation of their holdings increases substantially. However after the bubble, many asset holders will have lost money (that is, the asset they hold is now worth less than the price they paid for it).

The key here is that value is neither created nor destroyed in these stock market bubbles (assuming they don’t create systemic instability), it is simply transferred. Value is transferred from the new incoming buyers who pay a high price during the bubble to the existing holders of the assets who liquidate their holdings before the bubble collapses. After the bubble the same amount of value exists as at the start of the bubble, it is just in different pockets.

When trying to identify if an asset price surge is justified, try to identify if real value is being created for real people, or whether everyone is just suffering from irrational exuberance.

Summary

• There are 2 key concepts of value in a transaction, the price paid (the “

  exchange value

  ”), and the utility received (the “

  use value

  ”).

• Value creation occurs when a company creates more in

  use value

  from its products than it consumes in

  exchange value

  during production.

• Value capture occurs when a company is able to retain some share of the value it creates as profit.

• Just because a company creates value doesn’t mean it will necessarily capture any of it.

• The proportion of value that can be captured depends on the level of competition (amongst other things).

• Asset bubbles do not create or destroy value, they just transfer it between various parties.

References

1. Bowman, Cliff & Ambrosini, Véronique. (2002). Value Creation Versus Value Capture: Towards a Coherent Definition of Value in Strategy. British Journal of Management. 11. 1 - 15. 10.1111/1467-8551.00147.

2. Buffet, Warren (2009).

   2008 Shareholder Letter

   .

3. Evans, Benedict (2021).

   Does Amazon make more from ads than AWS?