Intrinsic Value

We mentioned that intrinsic value is an estimate of value based on the present value of cash flows. In its simplest form an equation for intrinsic value is:

We will discuss the math behind intrinsic value in Chapter 11. Why is this superior to market and book value? Most importantly, the intrinsic value model is cash flow–based. Cash flow is defined as benefits less costs and taxes. Research has shown that the value of companies has a strong correlation to value.^[1] This method is more conducive to analyzing SAs. Alternatives that involve changes to the way companies do business are difficult to value, based on market and book value concepts. Reengineering, for example, would most likely be accounted for as an operating expense and not an asset. Hence, a book value calculation could not be used. It would be difficult to find a market for a reengineering initiative because of the specialized and proprietary nature of this alternative. In addition, the intrinsic value model is forward-looking. It focuses on future cash flows.

This valuation concept is not without weaknesses. If assumptions are performed incorrectly, such as in estimation of cash flows and time/risk adjustments, the quality of the analysis is just as flawed as the market and book value models. We will deal with the weaknesses and how to offset them in the section dedicated to discounted cash flow in Chapter 11. On the other hand, the intrinsic value model has the best fit for our purposes.

^[1]McKinsey & Company, Inc., Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd ed. (New York: John Wiley & Sons, 2000), p. 77.