What Does Intrinsic Value Mean?
The intrinsic value of a company is obtained by conducting a valuation of a business, rather than by looking at comparables or other technical analysis. The valuation method used to determine the intrinsic value of the company can be different depending on the type of company being analyzed. For example, the capitalization of earnings or cash flow would be used for a company that operates in a stable environment with recurring free cash flow. However, for a company that has future free cash flows that may move up or down due to significant capital investment (or another reason), the discounted cash flow method may be a better tool to determine its intrinsic value.
Divestopedia Explains Intrinsic Value
The key consideration to understand is that the intrinsic value of a business can be (and usually is) very different than its price. The calculation of intrinsic value follows some key fundamental tenets which include: (1) highest and best price available, (2) open and unrestricted market (3) between informed parties (4) acting at arms' length, (5) properly informed and (6) the valuation being determined in pure cash consideration.
When price is determined, it can be very different than a target's intrinsic value because its tenets are seldom in place. The parties may have very different motivations, information available or negotiations skills. In most cases, the buyer has specific plans for the acquisition that may encourage payment of a price that is higher than the intrinsic value because the buyer believes the synergies achieved will improve the performance of the combined entity. As well, the buyer or the seller may be working through the transaction with some emotional element attached to the process. For example, a seller who has built a 20-year business with his/her name attached to it may believe that its price is much higher than its intrinsic value as determined by a proper valuation.