Johannesburg, 16 Oct 2019
Aaron Gilcreast and Larry Jones suggest, in the Spring 2018 issue of strategy+business, that “share price is, by its nature, an output: a complex, rolled-up reflection of company performance, conjecture, fickle asset-class preferences, risk appetite, ownership mix, supply-demand equilibriums, and fluid expectations held by millions of shareholders who can change their minds in a millisecond”.
So, let’s look at share price versus intrinsic value in a transaction or acquisition.
What’s the difference?
Share price represents the highest amount that someone is willing to pay, or the lowest amount someone is willing to accept, for a publicly listed stock.
Intrinsic value represents the value assigned to an entity as a result of fundamental analysis: a variety of models that evaluate qualitative and quantitative characteristics to determine what one would consider to be the real value of a firm.
However, intrinsic value remains subjective, with different thinkers placing different degrees of importance on different factors. There is, and can be, no standard comparison, because the environments in which firms operate are so different.
What’s more, while the share price of a publicly listed stock takes into account the intrinsic value of the entity, the former is also subjective, because it is significantly affected by market expectations and investor demands.
A practical comparison
The implication of share price versus intrinsic value in a transaction generally represents a benchmark at which one determines the price they are willing to pay for the desired shares, with an indication of whether that share is over- or under-priced relative to the purpose of the transaction.
For example, while the share price/intrinsic value may determine the subjective value of a firm today, the value of that firm in light of operations post-transaction may differ.
This explains the willingness of investors to pay a premium, because the post-transaction landscape, including post-transaction synergies, may represent an improved value proposition compared to that of the target entity alone.
What to focus on
While the share price metric may be heavily affected by sentiment, a commitment to driving operational efficiencies generally translates into better financial performance and cash flow generation, which is a key indicator of intrinsic value.
This, in turn, improves the value of a business and the potential shareholder returns through potential sale and dividends.
As Gilcreast and Jones (2018) suggest, the only factor that you have any control over is company performance. If you can focus on managing your business in a way that adds real intrinsic value, value that is sustainable over the long term, you are, in this way, affecting the only metric that you can meaningfully control. This should help you to successfully generate real return, regardless of valuation methodology.
So, is intrinsic value the winner?
Not entirely. Companies looking to be acquired should be aware that you don’t necessarily achieve a valuation representative to your true intrinsic value.
As easy as it is to say that a firm ‘should’ be valued according to intrinsic value, the truth is that it’s often impossible to meaningfully quantify. That’s why the share price of a publicly listed company is often used as the starting point for valuation; as the entry-level negotiation point.
However, with share price being time-sensitive because of market conditions, you could find yourself, during a period of general investor pessimism, with the starting point for valuation being lower, regardless of the firm’s real performance and resultant intrinsic value.
Tips for calculating value
At Sebata Holdings, we’ve always believed that value calculations should be based on the critical success factors that are specific to the firm’s environment. For instance, we value the quality of intellectual property as a key indicator of a firm’s intrinsic value, while this may not be the case for other firms.
It is crucial to determine the critical success factors relative to your business, and to then identify the metrics that represent intrinsic value within the context of those success factors. These should form the basis for identifying the true value of a firm.
In conclusion
Investors demand one thing: return on investment (ROI). While a share price may fluctuate according to peaks and troughs, associated with market sentiment and the performance of a business relative to the market, it is not the sole measure for ROI.
The value of an investment is always relative, as we believe the valuation methodology should be. For more information, visit www.sebataholdings.com
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