"Berkshire's arbitrage activities differ from those of many arbitrageurs. First, we participate in only a few, and usually very large, transactions each year."
-- Warren Buffett
A true arbitrage is riskless, such as agreeing to simultaneously buy and sell a barrel of oil (while accounting for transaction, transportation, and tax costs) at a profitable spread. However, true arbitrages rarely exist, and if they do, it's usually only momentarily, because capitalists will quickly bid up the underpriced oil and sell the overpriced oil and close the spread.
Arbitrage spreads are at the heart of all profit-seeking transactions, whether by individuals or businesses. We go to college because a lifetime of higher earnings power usually outweighs the tuition and opportunity costs. JPMorgan Chase
We can use arbitrage spreads to estimate the value of a business. To start, we need to ask three questions: How wide is its arbitrage spread, how long will it last, and how much risk am I taking?
Big arb or little arb?
The firm Long Term Capital Management was built on the principle of capturing teeny, tiny arbitrage spreads. For example, an "on the run" Treasury is the one most recently issued by the U.S. government, and an "off the run" Treasury isn't the most recently issued. On-the-run and off-the-run Treasuries, even if they have the exact same maturity, issuer (the U.S. government), and cash flows, will sometimes trade at small price differentials because of liquidity differences and market distortions. Capturing this small price differential -- sweeping up nickels is how Long Term Capital Management thought of it -- is an example of a tiny arbitrage spread.
Every business has to spend money to produce its product or service, then sell it for a price to customers, thus earning a spread on the difference. For example, Coca-Cola
Fast-acting or long-lasting?
Wait a minute: Who wouldn't want to make mouthwatering operating margins like that? Well, the problem is that Coke and Coach have competitive advantages. When consumers buy Coke and Coach products, they buy them by name. If you produced Foca-Cola and Foach and tried to sell them, you wouldn't be able to sell them for much, and you'd probably get sued.
The simple question to ask is, why are these companies able to exploit this pricing spread, and how long will they be able to do it? In Coach's and Coke's case, customers identify with the brands, which are reinforced through constant advertising.
However, looking at the source of the spread, Coke has a brand that is almost handed down through generations -- as with many of the most successful brands. For example, families take their kids to Disney
On the other hand, Coach, which has a great brand, depends more on women's fashion tastes, which can be more fickle. Although companies like Louis Vuitton have managed to exploit this spread for a long time, it's a tougher game with much more cutthroat competition. I'd clearly prefer to have Disney's arbitrage spread.
What's the 60-40 proposition?
This ties in to the point above. The more risky a spread is, the less it is worth. For example, Wal-Mart
Thus, the value of a business is a function of the width, durability, and riskiness of the spread between its production and selling costs. Of course, there's more to it (return on capital, time period, growth, etc.), but these three key components are a great start to valuing a business.
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Coca-Cola and Wal-Mart are Motley Fool Inside Value recommendations. Disney is a Stock Advisor recommendation, and JPMorgan Chase is an Income Investor recommendation. Try any one of our investing services free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.