Ask Colin

How is intrinsic value calculated for a company and how is it used?

Intrinsic value is one of those things like motherhood. Everyone knows and understands what it is, but when you try to define it you find there are many definitions, depending on who you talk to.

The idea is that every asset has an intrinsic value. If you own a car or a house and I ask you what you think it is worth, then what you tell me will be its intrinsic value as far as you are concerned.

However, if you ask some professional valuers to tell you what the car or house is worth, you are likely to get a different answer from each and they are all likely to be different to your figure.

Valuing a company is the same. If you have ever followed a takeover offer, you will notice that both the target company and the predator company have so-called INDEPENDENT expert reports prepared. What these are is the intrinsic value (it might be a range of values in practice, depending on certain assumptions) that each expert puts on the company. Lo and behold, the intrinsic value that the target company's independent expert comes up with is invariably higher than the intrinsic value that the predator company's independent expert comes up with. This brings a whole new meaning to the word INDEPENDENT.

The above might be cynical, but it highlights the issue that intrinsic value is not an objective thing. It will depend entirely on the assumptions that are made about a whole range of variables that affect forecast earnings, cash flow, dividends and so on.

There are a number of ways that these experts go about determining intrinsic value. There are PE multiple methods, dividend discount models, discounted cash flow models, the capital asset pricing model and many more, some for specialised situations.

Once the expert analyst has arrived at their intrinsic value for the company, it is divided by the number of shares issued and this gives the intrinsic value for each share. This can now be compared to the price in the market. If the market price is near the intrinsic value, then we say that the shares are selling at fair value. If the market price is above the intrinsic value, then the shares are expensive. If the market price is below the intrinsic value, then the shares are cheap.

One way that is used to deal with the range of values that analysts come up with is to collect them all and boil them down into a consensus value. There are agencies that produce these consensus valuations, mainly for the professional market, but they find their way into the media from time to time.

It is also worth noting that analysts tend to only cover the main companies. There may be many analysts covering a top-50 company, but only one or two covering a much smaller company and nobody covering the majority of small companies.

Keyword: