Perfect Opportunity Cost – and the Ideal Conditions to Buy or Sell an Asset
Perfect Opportunity Cost Introduced
This article strives to accomplish what many have tried – coin and define a new economic definition, Perfect Opportunity Cost.
The definition is derived from two well-known economic concepts, opportunity cost, and perfect competition, defined below:
- Opportunity cost - the forgone benefit that would have been derived from an option not chosen
- Perfect competition - occurs when all companies sell identical products, market share does not influence price, companies are able to enter or exit without barrier, buyers have perfect or full information, and individual companies cannot control market prices for commodities.
Perfect opportunity cost occurs when a buyer or seller has perfect or full information about a defined set of investment alternatives.
A Simple Analogy for Perfect Opportunity Cost:
Imagine you are a farmer in a small town, your tractor breaks down and you must buy a new one. Conveniently, all 5 of the major tractor manufacturers in the US are represented in your town and each has its full inventory available on the lot for purchase. This means you can get your operation back up and running quickly. The vendors are in varying proximity to your farm, but you can visit each and every dealership in town and get complete knowledge about all of the available tractors for purchase, including prices, features, and shipping information.
Being the financially savvy farmer you are, you select your top tractor choices and assign a return on investment (ROI) to each. You include a margin of safety equally across each option and assess the probability that you are correct on your various estimated ROIs. You now have complete information related to the comparable options and a clear picture of probabilistic returns on investment.
You have perfect opportunity cost, and the best decision becomes certain as your next best alternatives and their alternatives are fully quantifiable.
Rare Situations of Perfect Opportunity
Situations like the above are rare in more complex systems. In reality, most buyers or sellers of goods could only hope to approach perfect opportunity cost. Time, cost, and general feasibility will typically deter individuals from understanding perfect opportunity cost fully. An analogy from calculus, where an equation approaches a limit but never reaches it, is a more apt comparison.
Well-reasoned questions about the analogy presented will naturally include: What about the internet? What about purchasing a tractor from an overseas manufacturer? What about manufacturing your own? What about buying used?
Perfect opportunity cost must account for all available alternative options that are reasonable and can be knowable.
Admittedly, the definition of perfect opportunity cost is a non-reality for many complex systems.
Perfect Opportunity Cost in Investment
If you think about the problem of investing, the investor with the best-sustained performance must exhibit characteristics of perfect opportunity cost.
By definition – shouldn’t the investor that has exhibited the best performance of all other investors, have demonstrated perfect opportunity cost?
Yes, but actually no.
Yes, because the performance of all other investors is relative to their performance. They clearly had the best and biggest set of information for a long time.
No, because there is no conceivable way this investor could have complete market information. There is simply too much information for a human person to consume, let alone hold universally present in their mind at one time.
No again, because performance is relative and measured over time.
This investor must have had a better set of alternatives than the next best investor for a comparable period. You might say they had perfect relative opportunity cost. The same constraints the farmer faced with the time, cost, and general feasibility of getting the data to understand the total set of tractors available to purchase apply to investors buying companies in public and private companies.
Perfect Opportunity Cost in M&A
Achieving perfect opportunity costs when conducting M&A in private markets is complex. Information on private companies is hard to come by. Private firms don’t transact often and when they do that information must generally be packaged in a relatively uniform way. Competition is fierce.
So, what is a good M&A professional to do?
Let’s walk through an example of Company X, a large acquirer of small businesses in the US. As of 2022, the US M&A market is roughly 4.5% of GDP and small businesses account for about $1T of this $2T market.
Last year, Company X completed $250M in acquisitions with one employee focused on M&A. Company X is a real company. They are the largest company in their niche and have acquired more of the market than any other interested party. As a result, they are the largest owner of a particular type of business or very nearly the largest. They are on pace to be the largest business in their segment through acquisition.
How did Company X execute this strategy?
Company X Strategy
- The company quite literally hired every buy-side advisory firm in their target market to cold call and engage relevant business owners.
- The parent company of Company X, Big Box Corp, has a team that covers and regularly communicates with all IB firms in the universe of IB firms knowable in the US. ( They do this to assist their various platform companies).
- The company hired separate independent brokerage companies to similarly cover the total market, telling them overlapping communication is ok!
- The M&A professional hired contractors to assist with the transaction and enhance his time leverage.
Despite the fact that not all companies in the universe that company X wanted were for sale at the prices they wanted to pay, Company X effectively cornered the private market on their targeted transactions. In the nearest possible sense, the company built its way to what amounts to perfect opportunity cost in their market.
The example of company X represents the reality of what Perfect Opportunity Cost looks like in the real world. Viewed from a biological perspective, company X spent the money and built a strategy to be the biggest buyer in a given market. There was no bigger fish to compete against and so it developed perfect relative opportunity cost.
The vast majority of Entrepreneurs starting down the acquisition path are best served by focusing on a narrow problem. Perfect opportunity cost is achievable in submarkets by tenacious entrepreneurs. When market information can be maintained over an extended period of time the information can also be used to disproportionate effect when prices are favorable.