Archive for the 'Intrinsic Value' Category

Intrinsic Value is an all-important business concept. The expression speaks to what the true worth of an enterprise. How, though, does one know the Intrinsic Value of an enterprise?

An enterprise’s Intrinsic Value is equal to what its free cash flows, appropriately discounted, are really going to be.

This might sound basic. If you know the future cash flows and apply an appropriate discount rate, you will know Intrinsic Value.

The overwhelming criteria for making business decisions is (or at least should be) the quest to maximize Intrinsic Value. That is, the singular focus when evaluating a decision should be the cash flows that will really result from the range of choices available.

A mistake often made by businesses is overweighing the need to beat their budget for revenue, EBITDA, or capital. No doubt that missing a budget will have immediate and typically negative ramifications. What if, though, management has opportunity to satisfy budget expectations by making decisions that are sub-optimal to Intrinsic Value?

This choice occurs frequently. Though unspoken, the temptation to overlook Intrinsic Value optimization in favor of achieving budget goals is high. It can be rationalized as well. “We always make our numbers.” A true commitment to Intrinsic Value means that maximizing Intrinsic Value will trump making budget.

Generally speaking, the pace of revenue and EBITDA growth positively influences the value of an enterprise. Growth can be accelerated through decisions that are suboptimal to maximizing Intrinsic Value. Same question as earlier: What if management has opportunity to show higher growth through decisions that are sub-optimal to Intrinsic Value? Will they resist the temptation?

Management rarely approves a business plan that shows a poor IRR or lousy NPV. Does this mean all approved business plans maximize Intrinsic Value? Let’s focus on the words “what free cash flows are really going to be”. The question shifts to whether the business plan is an accurate portrayal of future cash flows. Often, too little scrutiny is placed on the accuracy of the cash flow prediction. A good faith attempt to accurately forecast isn’t sufficient. At the end of the day, Intrinsic Value will reflect the real cash flows, not  the business plan forecast. Competency, in the area of business plan analyses, is tied to the degree of accuracy of cash flow predictions. To what degree does a management team focus on knowing and improving the accuracy of their predictions?

Most industries have rules of thumb for approximating the enterprise values. Telecom often uses EBITDA Multiple. Revenue multiple is used in earlier stage growth industries, and EBIT Multiple is used in more mature industries. Management teams must realize that none of these is an acceptable proxy for Intrinsic Value. Management must maintain its focus on Intrinsic Value, and use its ever-improving understanding of Intrinsic Value to guide thinking around rule of thumb multiples of a simple accounting metric.

Intrinsic Value is a simple concept. It is true worth of an enterprise, and will be revealed as the true free cash flows play out. A management team’s commitment to using maximization of Intrinsic Value as the overwhelming compass for decision-making is paramount. This commitment cannot be compromised even when confronted by conflicting goals such as achieving budgets, growing revenue, or funding interesting projects.

In this entry, I want to cover an all-important business concept. An enterprise is worth what its free cash flows, appropriately discounted, are really going to be; this is my definition of Intrinsic Value.

At first blush, this might seem obvious to some. Or, to others, it might seem wrong.

For example, isn’t a public business worth its “enterprise value”? For those who don’t know, enterprise value can be calculated by summing the the value of debt and equity a public company. Equity value is basically stock prices times the number of shares outstanding. Many people would say an enterprise is worth its “enterprise value”.

University of Chicago, of which I am an alumni, invented the “efficient market theory”, which states that the most accurate estimate of of the value of a public company is it’s enterprise value. Warren Buffett likes to point out that if the efficient market theory was correct, he would more likely be a pan handler than the world’s 2nd richest man. Said differently, enterprise value is sometimes out of sync with intrinsic value.

Berkshire Hathaway has done phenomenally well because it has an incredible record of determining intrinsic value. It invests when it identifies situations where intrinsic value is materially higher than enterprise value.

In the previous blog entry, we discussed how important it is for a company to develop a strong expertise in forecasting cash flows. This skill set ensures that a company is capable of accurately estimating its enterprise value as well as how day to day business decisions either enhance or detract from value. The better a company does at predicting cash flows and in tying cash flows to the true value (true = intrinsic) of their enterprise, the more valuable the enterprise will be.

Warren Buffett has a strong conviction about an executives’ responsibility in communicating intrinsic value to its investors. His opinion might surprise you as it is arguably in contrast to the behavior of most public company CEOs.