somrh (92.27)

Intrinsic Value - a phrase that ought to be abandoned

August 25, 2012 – Comments (1) | RELATED TICKERS: GRPN

In Prof. Damodaran's recent post on GRPN, he makes some comments about "intrinsic value" which I'd like to discuss. I've long thought the term is a misnomer so I will attempt to flesh out some of my critique. I'll be using his brief comments as a means of engaging the topic.

To summarize my current position, I think "fundamental value" or "present value" are more appropriate terms. I think they are functions of time and therefore can change over time. Here's the excerpt from Prof. Damodaran's post:

Intrinsic valuations can (and should) change over time: There is deeply held belief, at least in some quarters, that intrinsic valuations are stable and don't change over time. While that may be true in many companies and most time periods, there are three exceptions. The first is a dramatic change in the macro environment. My intrinsic valuations for almost all companies changed between August 2012 and October 2012, as the market price of risk (in the form of equity risk premiums and default spreads) increased dramatically in the aftermath of the banking crisis. The second is when accounting fraud is uncovered and key numbers have to be restated. The third is with young growth companies where the premise on which the value of growth is based - that it is scalable, defensible and valuable - is called into question. It is the third exception that applies to Groupon and I feel comfortable lowering the value per share from $14.82 a year ago to $4.07 today.

His first exception is regarding "macro environment". He makes reference to the "market price of risk" which relates to changes in the discount rates used. If you alter discount rates (such as interest rates for bonds) that changes the value. This exception, to me, is not a claim that intrinsic values changes but that value depends upon external factors. I concur that the value can be altered by external factors but that is evidence that value is not intrinsic. 

His last two exceptions are references to accounting fraud (in which reported figures are incorrect) and where "the premise [...] is called into question". One could argue that this doesn't change the actual value of the firm but our assessment of the value of the firm. The problem is the value of the firm depends upon, for example, future cash flows of the business. I don't know if the future can "change" (or what it means for the future to change) but I do know that the future is not known nor certain and so our assessment of the future can frequently change. 

The last point I would make is regarding a fundamental reason why the value of an asset changes over time. To give an example, we'll look at a basic cash flow model that assumes perpetual growth. The present value (PV) is then a function of current cash flows (CF), growing at a rate G and discounted at a rate R given by:

PV = CF / (R - G)

Notice that PV/CF (which is a price multiple) is constant for this model. As a result as cash flows grow over time, the price of the cash flows will grow over time. This illustrates how the value of the asset can change over time while nothing fundamentally has changed about the asset.

Using a concept like "present value" emphasizes the time element of the value. If something is worth $10 today, that doesn't mean it will be worth $10 tomorrow. Tomorrow is a different time and affords a different "present value".

For these reasons, I think the phrase "intrinsic value" should be abandoned and replaced by "present value" or "fundamental value".