Is Intrinsic Value the Most Important Thing in Investing?

Many people may be familiar with investing in common stocks as growth vehicles in their financial portfolio. With information a click away on the internet and various books just as available on investing, it seems that everyone has the power to manage their own portfolio like they were a professional investment manager.

Many of these sources point toward Warren Buffet's style of investing, commonly known as value investing. The premise behind the strategy cites that investors own a small piece of a company. The basic philosophy is that a good investment is made in good companies selling at a discount to their intrinsic value.

However, caution and an analytical approach should be taken when defining intrinsic value, which is loosely defined as the price at which a person would be willing to pay for the whole business. This assumption is vague and not useful in practicum at all.

The truth about intrinsic value is that it is subject to the participants involved, meaning that, depending on the buyers and sellers own reasoning, intrinsic value will differ. If you were a small bank up for sale, you would most likely charge a far lower price to a private buyer than you would, say to Bank of America. This is mostly because variables such as the size of the buyer and synergy value come into play.

Furthermore, intrinsic value differs between how the buyer or the seller are evaluating it. While things such as future earnings are factored into both perspective values, there are variables that will discount the value of the business on the side of the buyer that would not affect the value to the seller. These are things such as lack of liquidity and non-diversifiable risk.

Likewise, the value of the business to the seller will factor in the size of the buyer that would not affect the value calculation on the part of the buyer. As a buyer, how big the company is should not make me change my estimate of what another prospective company is worth to me, but it will to the seller.

How Much Is That Business In The Window?

Let's pretend for a second, you are the owner of a dry cleaners business. Business has been good the past few years, you've managed to grow your business at about 20% per year by opening a few new locations. You've even managed to sock away about $50k per year in cash after all expenses and re-investments. You remember back only four years ago that with only a $15,000 investment, you've come a long way.

One day, a representative from a larger chain of dry cleaners, comes in and offers you $250,000 to buy you out. Do you take the money?

Knowing the value of your business is a crucial part of being a business owner. Unfortunately, the price of a business is not as clearly defined as say, the value of your house, which has comparables and mortgage value assigned to it by a bank. Unlike a single asset such as a house, anything that produces a profit takes a significant amount of financial analysis, future projections, and discounting to determine what the true value is.

In this example above, you'd be foolish to accept such a low price since a worst case scenario, valuation would still put your worth at well over $200,000. Ironically, about five years ago, insurance agents found themselves in the same scenario when a large insurance corporation came around offering independent agents a buyout price. Most of them had no idea what they were worth and were ill-prepared for the situation.

The truth of the matter is, a buyout proposition can happen at any time to any business, especially in highly fragmented industries that are cost competitive. It is the responsibility of the business owner to know what they're worth in multiple income scenarios so they can make sure the price offered is fair.

Hiring a skilled business appraiser is an investment in your business that will pay for itself many times over in the future.

I would suggest this to anyone who in the future plans to sell their business or pass it on to their children through their estate. You can do an online search for one in your area. Just make sure they have credible experience or are certified by one of the accredited valuation bureaus (IBA, ASA, NACVA, CFA Institute, or a CPA with a ABV distinction).

Having the financial transparency of a proper business appraisal will give you and anyone else the proper assurance that your business is worth the time and effort you put into it.