Intrinsic Value of a Business

What is the Intrinsic value of a business? Why would knowing the intrinsic value of a business be important?

If you decide to buy a business one day, or decide you want to start investing in individual stocks, or want to determine the costs around building your own business and trying to make it profitable - determining its intrinsic value will be extremely helpful in your quest. But where do you start?

First of all, what does intrinsic value mean? I'll try to make an analogy. Have you ever thought about why gold has value? Its just a natural element of the earth, but because it is a rare precious metal and has great properties, its accepted in exchange for goods and services. Thus, people accept Gold as something with value. Otherwise, its just a worthless metal.

In a business sense, intrinsic value is the minimum underlying value of something which is accepted for exchange. Another simple example is, if people believe one pound bread is worth two books, then the intrinsic value of one pound of bread is two books. It can also be said that the intrinsic value of two books is one pound of bread. Otherwise, it's just bread and books.

Factors of Intrinsic Value

How then do you determine the intrinsic value of a business? Obviously, you can't use a business as a medium of exchange and a business is not backed by gold..or bread and books for that matter. So what gives a business its intrinsic value? Two factors:

  • Quantitative
  • Qualitative

These are the two general approaches in finding the intrinsic value of a business. Both can have tangible or intangible objects of value; it all depends on what type of goods and services the business provides.

Quantitative Factors

Tangible:

  • Capital. All businesses must have capital to operate. Cash is king! Capital is the most important resource in a business.
  • Cash Equivalents. The business might own assets that can be sold off quickly in return for capital. Basically, anything the company owns can be quickly and easily liquidated.
  • Plant, Property, and Equipment (PPE). The value of all the businesses property is also added into it's intrinsic value. Keep in mind that these assets can depreciate and are not always worth what is stated.
  • Inventory. A business may have inventory that has not been sold yet, but still holds value.

Intangible:

  • Accounts Receivable. This is the amount of cash that the company has NOT received from buyers of their products and/or services, but will in the short-term future.
  • Branding. For example, the double golden arches of McDonald's is worth A LOT of money. It is recognized around the world, and if you were to buyout McDonald's (got a few tens of billions?), you would pay a premium for those golden arches.
  • Copyrights and Patents. The business may depend on these to have a competitive advantage with their product or service. If these did not exist, everyone would be able to go around and copy other businesses, which means loss of revenue and profits.
  • Goodwill. Not meaning that a company has good intentions, but it is an amount that represents when a company (usually larger ones) buys another company and "overpays" for it because the buyer company believes it has good potential and is worth more. It is a confusing concept for some so don't worry about it too much.

Want to determine the quantitative intrinsic value of a business? It can be found on the business's financial statements! In its most general form, a business is worth all its assets minus its liabilities. This determines "net worth." All the quantitative factors listed above are accounted for in a business's balance sheet. Keep in mind not every item in the list is included on the balance sheet for every business. For example, some businesses do not have Goodwill.

Qualitative Factors

Tangible:

  • Product. Ever notice how one company's product has better quality than the other company's? It is tangible and people are willing to pay extra for it.

Intangible:

  • Management
  • Marketshare
  • Competitive Advantage vs Competitors
  • Business Model of the Company - Including its Mission, Plans, Strategy

How can you put a price on a business's qualitative factors to determine intrinsic value? Well, if I asked you if you would buy an mp3 player between Apple or from Generic Labs with the same functionality, which would you rather have? Apple of course! You recognize the brand and you the associate brand with quality. You don't really have to think about quality issues with Apple's products, but you might question Generic Labs. So to get a little more assurance, you will probably pay extra and are willing to pay it. Therefore, Apple's brand name has more qualitative value to it. So, when you're willing to pay for it, Apple's qualitative intrinsic value increases.

Now if there was a problem with Apple's quality, then it's intrinsic value would go down obviously, but sometimes in more ways then one. Therefore, its important for a business to build a reputation around quality. Qualitative problems with products can almost always be traced back to management - that intangible qualitative factor. Think about how Toyota feels after all the recalls for their cars! Toyota was the industry quality leader, people paid for the quality of the Toyota name, but they got too comfortable - management either slacked off or allowed quality problems to pass through!

There are also other bullets to point out, but the ones listed above are some of the important and most useful ones and to keep in mind.

One Up On Wall Street: How To Use What You Already Know To Make Money In The Market
One Up On Wall Street: How To Use What You Already Know To Make Money In The Market

Peter Lynch tells you what to look for Quantitatively and Qualitatively in this classic best selling book!

 

Importance of Intrinsic Value

Why is the intrinsic value of a business important?

As I stated in the beginning of this article, if you decide to buy a business one day, or decide you want to start investing in individual stocks, or want to determine the costs around building your own business, determining its intrinsic value will be very helpful in your quest. Intrinsic value assesses what a company is worth by taking into account the quantitative and qualitative factors. Knowing this gives you information about a business before taking any part in it.

Quantitatively, one can put a price on a business after analyzing a business's financial statements and determining its intrinsic value. However, a business's intrinsic value does not necessarily have an exact formula based on variables from the financial statements. A company's intrinsic value varies from one person to another. For example, an analysts who looks at financial statements may say a company's inventory is not worth much while another analyst thinks its worth much more.

There are some investors who seek only to find the quantitative intrinsic value of a business. These investors are known as value investors, a concept taken from fundamental analysis (for information on fundamental analysis click here). Investors of this type look at individual businesses, once the price of the business goes lower than its intrinsic value, they pounce on the opportunity.

If you do not know who Warren Buffet is, he is considered the greatest investor of all time. Why? Warren Buffet is the type of investor who pounces on those price opportunities. In fact, he makes his investment decision before the price opportunity arrives and waits patiently for months, sometimes years, before the opportunity comes. Its like the old saying, "luck comes to those who are prepared." What sets him apart from pure intrinsic value investors is that he knows how to factor in qualitative factors also.

Qualitative factors are hard to put a price on; it is more difficult for investors to grasp its worth. The competitive advantage of a business versus other competitors usually depends on management decisions, innovation, and creativity. Think about it this way, if you (and millions of others) are willing to fork up a few extra bucks on Apple's products because of its innovative quality products, then there has to be some intrinsic qualitative value there - something with a price on it.

So, it is up to the individual to find the intrinsic value of a business depending on what they believe are the most important factors and how much weight each factor should carry.

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IVI Guy profile image

IVI Guy 2 years ago from New York

Warren Buffett's letters to shareholders of Berkshire Hathaway has a lot of good information on intrinsic value. Also, I like Joe Ponzio's "F Wall Street" which provides a detailed explanation on how one might calculate the intrinsic value of a stock.

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