Friday, February 8, 2008

Market Value vs. Intrinsic Value

I'd like to tackle the issue of firm valuation. Determining a firm's value is especially important for start-up firms under consideration for venture funding. Establishing, maintaining, and increasing a start-up's value is central to the reason the firm was founded and for utilizing venture capital and investment provided to it.

This introduces an item that requires further clarification - the definition of "value." Value can be generally defined as "a fair price" or as "utility" or "worth" (courtesy of the American Heritage Dictionary...).

In the financial world, it's common to differentiate among types of "value." Specifically, there is a difference between an asset's "market value" and its "intrinsic value." Market value is the value that someone else places on an asset - what that asset is worth to some other market participant. Intrinsic value is the actual value or worth of a firm.

This fundamental difference in values supports the argument that the true value of a company is not necessarily reflected in the market valuations given to them by other market participants. The case I referred to was Microsoft's $15 billion valuation of Facebook. Valuations generated by venture capitalists or other related suitors nearly always tend to be market values, and not a reflection of a firm's intrinsic value.

If a VC values a company at $100 mln, and makes a $10 mln investment, that means that they have purchased 10% of the company. That initial $10 mln investment may be (or at least should be) entirely necessary for the target company to propel itself for product development, sales, and eventually profit. However, given that VCs are wrong on their company valuations 90% of the time, the $100 mln valuation is solely based on the market value - what the VCs are willing and able to pay for some asset.

In this case, they are willing and able to pay $10 mln for 10% of the company. Surely they would be willing to pay less that $10 mlm for 10% of the company, and alternately, the company owner would surely be willing to sell less than 10% of the company for $10 mln. But assuming that the VC and the company operate in a competitive market, this $10 mln investment for 10% of the company represents the market equilibrium price for the asset (the asset being 10% of the start-up).

This market price doesn't necessarily mean, and in most cases, does not mean that the intrinsic value of the start-up is $100 mln, only that the market value of the start-up is $100 mln. In fact, with the 90% failure rate of the VC industry, it stands to reason that the market valuation of the company is quite overpriced, but because there is a willing buyer and seller, a market for the 10% of the company is created.

With a couple of fundamentals definitions, we can begin to see how the market valuations for start-ups and new media companies may be incorrect a high percentage of the time, with these errors tending to overvalue a firm rather than undervalue a firm.

It's a point of frustration to see artificially high market values placed on firms (whether they be start-ups or publicly-traded) when it is clear the economic or intrinsic value of a firm can be clearly argued to be much lower.


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