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.

One Response to “Intrinsic Value and Temptations in the Garden of Eve”

  • Parkite says:

    Inorganic growth can, and usually does, lead to suboptimal decisions as it pertains to IV. Grow the top line!!! You need to be very, very disciplined when pursuing an inorganic growth story. Disclaimer – this is not a commentary on Zayo.

    Also, much easier to not fall victim to making suboptimal decisions if a private vs public enterprise.

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