Continued from Part 1, in this article, we will discuss two of the five methods of business valuation: intrinsic value and investment value.
To determine the Intrinsic Value of a business, a valuator will compare the difference between the business’s value as calculated through a valuation with the value of the business being traded in the open market.
Expressing this numerically, if Acme, Inc. is trading in the market at $50.00 per share, but the value of the company is $75.00 per share when analyzed by a valuation professional, then Acme, Inc. has $25.00 of intrinsic value. $75.00 – $50.00 = $25.00.
By this method, the Acme, Inc. stock is evidently undervalued, so an investor who noticed the opportunity this discrepancy provides could purchase the stock at $50.00 with the expectation that the stock will rise toward its true Intrinsic Value as other investors perceive the same opportunity. Of course, there is no guarantee that Acme, Inc. stock will appreciate to its Intrinsic Value, or, if it does, how long the appreciation will take.
Though largely a subjective valuation, Investment Value is determined by the abilities of an investor to perceive an opportunity and take action based on their skills and experience with appraising a situation. An investor calculates the opportunity using knowledge, risk analysis, return characteristics, earnings expectations and a variety of other assessment techniques. Here is an example to explain Investment Value:
The investment being appraised is a 100-unit apartment building offered for sale in a desirable community. Three investors are interested in purchasing this building as an investment for upgrade and resale.
The first investor’s business model is investing and managing apartment buildings, and he values the building at $100,000 per door for a total value of $10,000,000 (100 units x $100,000 = $10,000,000).
The second investor’s business model is buying apartment buildings and converting them to condominiums; he then sells them at a premium. This investor values the property at $150,000 per door for a total value of $15,000,000. (100 units x $150,000 = $15,000,000).
The third investor’s business model is buying properties and redeveloping them to their greatest potential for return. He can afford to pay $200,000 per door for a total of $20,000,000. (100 units x $200,000 = $20,000,000).
Investor Value Perspective Business Intention
Investor 1 $10,000,000 Manage apartments
Investor 2 $15,000,000 Convert to condos/resell
Investor 3 $20,000,000 Development project
Which investor’s perception of the apartment building’s value is the right one? Each investor saw a different opportunity and a different Investment Value based on their perception of a familiar outcome.
All three investors are correct with their individual valuations because each of them perceived a unique value based on their knowledge and abilities. This is Investment Value.
A business valuation is conducted for a specific purpose, and that purpose will determine which of the five standards of value will be applied in your valuation. The Fair Market Value standard is the most common because of its use by the IRS and the courts, though the other types are useful in particular circumstances. Valuations should only be conducted by trained, accredited professionals.