The principles of intrinsic vs. instrumental value
Anything bought or sold has value, but what is value? Value is defined as being either intrinsic or instrumental. That is, value is either something good in and of itself, or it’s a tool to obtain something that’s good in and of itself.
For example, money can be traded for a house in which families spend time together. The time spent with family is intrinsic and the money is an instrument.
The difference between intrinsic and instrumental value is at the core of company valuation.
Companies are not typically bought and sold based on emotions or other intrinsic notions. Investors don’t purchase companies because they are good in and of themselves, they purchase them for their instrumental value - cash flow.
At a fundamental level, the sale of a company’s products, minus costs, creates cash flow, or money that can be distributed to its owner(s). Cash flow is one of the three key factors to income-based valuation:
How does the discount rate impact valuation? A projection of cash flow is paired with a discount rate. Discount rates are meant to factor in basic required returns with premiums to address the uncertainties/risks of realizing projected cash flows. A discount rate goes up with risks, which has an inverse effect on valuation (that is, when risks go up, valuation goes down.)
Can you do the calculation on your own? Mathematically yes, but a calculation is not the whole picture of valuation. Knowing the market and its risk tolerance is critical to determine the discount rate and other key inputs.
How does the EBITDA multiple factor in? Earnings before interest, tax, depreciation and amortization (EBITDA) multiples are an output of discounting cash flows, or simply enterprise valuation divided by EBITDA. The cash flows are the input that drive the valuation, but the market needs an apples-to-apples approach to discuss valuation, and therein lies the EBITDA multiple.
Why is it important to know the value of your business? The owner of a business is not the only party that’s interested in valuing it. Financial institutions will value a business for lending purposes and the Internal Revenue Service will value it for tax purposes. Additionally, a business is often the retirement plan of its owner. How can you plan for retirement without knowing the size of your egg? If a business owner has more than one child and more than just the business to serve as an inheritance, independent business valuation will be crucial to determine who gets what as part of your estate plan. Finally, a decision to continue to operate a business is the same as a decision to buy the business; why not know what you’re paying?
Author’s note: We find that founder-owners benefit from having a third party assess their company’s valuation because of the challenge of separating the intrinsic value of their business from the instrumental value. Almost all founder-owners are proud of the years of hard work they’ve poured into their company, and while that pride is intrinsic, it doesn’t serve as a basis for market valuation.