A lot of times in valuation and investing, we hear the term “Intrinsic Value” thrown around. There are many different definitions that often accompany this term. Most often, it deals with an objective determination of an assets value through the use of fundamental and technical analysis. Although this can make a bit of sense on the surface, it is a fact that the analysis that is performed is based on observable rates of returns, multiples, and valuations of other assets. So, the term “intrinsic” seems a bit misleading, in my opinion.
I have become a fan of behavioral economics recently and have tried to get my hands on as much reading material as possible. I recently dove in to “Predictably Irrational” by Dan Ariely. On the second page of the book, I was pleasantly surprised to read the following paragraph, which I think explains beautifully a key principle in valuation:
“Humans rarely choose things in absolute terms. We don’t have an internal value meter that tells us how much things are worth.” Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly.”
This is an incredibly important point to consider when thinking about business valuation, although I have to admit that it would be awesome to have an internal value meter. What Dan is talking about here is key in understanding how the value of a privately-held, small business is determined. Value is not determined in a vacuum.
One significant area where this rings true is in the calculation of the appropriate discount rate in a discounted cash flow model. Let’s take a look at the cost of equity capital specifically. There are a couple methods to get the cost of equity and I think people have a hard time understanding what the cost of equity actually means.
No matter the methodology, the cost of equity should reflect the rate of return required for an equity investor to invest in the specific business interest. The cost of equity is not calculated in a vacuum, but is determined in relation to all other rates of return available on all other investments available in the marketplace. Let’s say the cost of equity is determined to be 25% for a specific investment. This means that a similar investment in terms of risk, would require a 25% return to its investors. Inherently, our valuation that is based on this discount rate is relative instead of absolute.
There are many other examples of our estimate of value as a relative measure as opposed to an absolute measure. We look at guideline public companies and completed transactions of companies that are similar to ours in the hopes of drawing conclusions as to the value of our company relative to the observable values in the marketplace.
Intrinsic value continues to be a confusing term, as it often relies on the data from other investments, which would inherently make it not intrinsic?
If you are wondering as to the value of your business, intrinsic or otherwise, reach out to DKB’s valuation team to see how we can help.