I learnt about this question awhile back doing management accounting and I felt this question is one of the best questions to ask yourself when making a decision. For example, you need a bicycle, make or buy? We mostly likely do not have skills and knowledge to make a bicycle so it's most likely we buy one. You are planning for dinner tonight? Eat in or out, make dinner on your own or buy it from somewhere. There's infinite examples when it comes to make or buy so I hope you get the basic idea.
A friend recently asked me why do I buy stocks/shares rather than start up a business? It came to my mind immediately it was a make or buy question. Starting up a business not only requires capital, it requires other attributes such as knowledge, management, research etc. It's certainly is not beyond a person to start a business but it is going to have a certain degree of risk. Until a person has the expertise to manage risk, the normal person usually buys. Unless you can make dinner for yourself, you do not have a choice.
Warren Buffett once said buying stocks was no different from buying a business. When you are buying a stock, you are essentially acquiring ownership of a business. Buffett as you know is a guru of buying, making his fortune in companies such as Coca-Cola, Kraft, Johnson and Johnson etc. He is one of the best examples when it comes to buying and he proves that you can actually succeed by buying. He looks for businesses with great potential and undervalued according to his analysis and buys them. His knowledge for his insurance business should also be noted.
Not every division of a great company is the best. And when it came to a video website for Google, it never took off like its other products.Google Video was nowhere. Google is the leader in the internet world and they have some of the most genius creations, but they couldn't create a successful site for videos. What did they do, they bought. They bought the world's most popular site for videos, YouTube. They paid a large sum of money for it, but it was a site they just couldn't match so they bought them out.
How about making? We've seen thousands of people creating their own companies and eventually growing them so huge and listing it in public. Robert Kiyosaki calls them the ultimate investors, people who create companies where the public wants a slice of it. People like Robert himself, Donald Trump, the Walton family (Wal-Mart), Larry and Sergey (Google) and soon to be Mike Zuckerberg (Facebook). An important term people like them like to be described as, entrepreneurs. I know there are many other prominent people I've not mentioned but you get the point. They are the king of making. Using their talents and hard work they created business worth billions of dollars. Think about Microsoft, eBay , Amazon etc, just imagine how far they can go from starting from scratch. People like them make companies and the rest of us buy them. We may not "make" a listed company one day, but rewards of a successful business can be very substantial.
So make or buy?Still a difficult decision. In terms of risk, it's a big debate. By having your own company, you decide everything that goes on and the business risk will be known and managed by yourself, there is no information asymmetry . The big question mark is expertise. If you have the expertise of making a bicycle which will cost less than the one at the shop, it should be a "make" decision. So do you have the capabilities and talents to carry out the "make" decision.
Having the expertise in buying or making can make you a lot money either way so understanding the key factors and differences is important when deciding. When you're buying a business and the business is not run by yourself, 99% of the time you would be facing agency cost. Agency cost occurs when interest of management is not in line with shareholders (owners) of the business and this will be a 'cost' to the shareholders. When you're buying a publicly listed stock, you generally do not have much control over the business and you are just hopeful the company in run properly by management and value is added to your investment.
As I mentioned, information asymmetry occurs and this can be a cost to shareholders. Management in a company generally will possess some "inside information"(non-publicly available information) which can be used to make money for themselves. Although there are laws preventing such actions, people who use this information still have means to get immunity in the form of disclosure. As a shareholder, value can be lost because insiders trade ahead of everyone and this takes a cut out of the potential profits of shareholders.
Although there are mechanisms in place such as corporate governance and employment incentives to align the interest of management with shareholders, agency cost will never be eliminated completely, which means the wealth of shareholders are transferred from them. Corporate governance has become a bigger issue lately with the collapse of big corporations, but this cannot fully solve the problems of agency especially when the directors are managers themselves or there is a lack of independence in the board of directors and management. More accountability is placed on the duties of directors but this does necessary reduce agency cost because it acts more in a form of punishment rather than being a deterrent. Thus shareholders will have to bear that risk and cost.
Almost all corporations give their employees the option to own the corporation's shares to motivate the employees. It will lessen agency cost but things like employee benefits, bonuses and perks are still coming out the pocket of shareholders. So are you comfortable with that happening?
Is agency cost minimal enough to overcome when "buying", that's probably an important question you have to ask yourself when making the decision. If you think management places too much interest on themselves, then "buying" would not be a good investment decision for you. There are many people who don't think management act in the best interest of shareholders and they stay away from the buy option. So it is up to your analysis to decide whether you can "trust" the company's management to run YOUR business. One of Buffett's most important steps to deciding on his investment is meeting with management. It is true he meets with management to see whether they are capable and dedicated enough to maximise the value of his investment. Lesson: He buys beyond the fundamentals of the business.
To succeed in your finances, you cannot avoid the make or buy decision. Some people avoid this decision completely and work for life. For the benefit of yourself, it's time to ask yourself, make or buy.
~deyao~
