FAQ: What is the standard of value? Part 2 of 2

Exit Insight: Getting to Sold!In our last post, we started a discussion of standard of value, giving a brief overview and explaining Fair Market Value. In this post, we’ll cover book value, intrinsic value and investment value. The following is an excerpt from pages 90-93 of “Exit Insight: Getting to ‘Sold!’”

Book value:

The third type of valuation standard is Book Value, which is actually an accounting term. Book Value is not often used in a business valuation because the value as registered in the company’s financial books is not necessarily a true representation of the entity’s value.

Book Value is derived from a business’s balance sheet of assets, liabilities, and the owner’s equity. Here is a formula that represents the relationship of these elements:

Assets = Liabilities + Owners Equity

Continuing this explanation, you’ll see in the formula below that Book Value equals the business’s net assets minus its liabilities as measured by historical costs. (Net assets are assets at historical costs minus accumulated depreciation, amortization and any depletion.)

Book Value = Assets – Liabilities

Yet another way of understanding Book Value is that it is the owner’s equity:

Owner’s Equity = Assets – Liabilities
Book Value = Owner’s Equity

Intrinsic value:

To determine the Intrinsic Value of a business, a valuator will compare the difference between the business’s value as calculated through a valuation with the value of the business being traded in the open market.

Expressing this numerically, if Acme, Inc. is trading in the market at $50.00 per share, but the value of the company is $75.00 per share when analyzed by a valuation professional, then Acme, Inc. has $25.00 of intrinsic value. $75.00 – $50.00 = $25.00.

By this method, the Acme, Inc. stock is evidently undervalued, so an investor who noticed the opportunity this discrepancy provides could purchase the stock at $50.00 with the expectation that the stock will rise toward its true Intrinsic Value as other investors perceive the same opportunity. Of course, there is no guarantee that Acme, Inc. stock will appreciate to its Intrinsic Value, or, if it does, how long the appreciation will take.

Investment value:

Though largely a subjective valuation, Investment Value is determined by the abilities of an investor to perceive an opportunity and take action based on their skills and experience with appraising a situation. An investor calculates the opportunity using knowledge, risk analysis, return characteristics, earnings expectations and a variety of other assessment techniques. Here is an example to explain Investment Value:

The investment being appraised is a 100-unit apartment building offered for sale in a desirable community. Three investors are interested in purchasing this building as an investment for upgrade and resale.

The first investor’s business model is investing and managing apartment buildings, and he values the building at $100,000 per door for a total value of $10,000,000 (100 units x $100,000 = $10,000,000).

The second investor’s business model is buying apartment buildings and converting them to condominiums; he then sells them at a premium. This investor values the property at $150,000 per door for a total value of $15,000,000. (100 units x $150,000 = $15,000,000).

The third investor’s business model is buying properties and redeveloping them to their greatest potential for return. He can afford to pay $200,000 per door for a total of $20,000,000. (100 units x $200,000 = $20,000,000).

Figure 34: Standard of Value Example

Investor Value Perspective Business Intention
Investor 1 $10,000,000 Manage apartments
Investor 2 $15,000,000 Convert to condos/resell
Investor 3 $20,000,000 Development project

 

Which investor’s perception of the apartment building’s value is the right one? Each investor saw a different opportunity and a different Investment Value based on their perception of a familiar outcome.

All three investors are correct with their individual valuations because each of them perceived a unique value based on their knowledge and abilities. This is Investment Value.

Copyright © Joseph M. Maas for Merrell Publishing 2014-2015

Want more information about exit planning or business valuations? Buy a copy of “Exit Insight” for online at Merrell Publishing or Amazon. A small investment today will give you great peace of mind later!