In this guide, we discuss what investment value is, how it differs from fair market value, and how to calculate it.
Mergers and acquisitions often discuss the concept of fair market value, but there’s also the issue of investment valuation. The market value of something is one thing, but investors often focus on investment value because it represents the value an investor would pay for an asset.
In Q3 2024, UK business investment increased by 1.9%, which coincides with the high confidence value amongst the country’s business community. Whether you’re buying, selling, or investing in a business, understanding investment value is crucial for avoiding a scenario where you’re overpaying or underpaying.
In this guide, we discuss what investment value is, how it differs from fair market value, and how to calculate it.
What is investment value?
Investment value is something that benefits all parties because it helps determine what a fair valuation is for a business. Technically, it applies to any asset an investor can invest in, and the principles remain the same.
In short, the investment value of an asset is determined by an independent valuation of an asset, such as a business. The investor decides on the value based on a variety of factors, such as the expected return on their investment and cash flow estimates.
Like valuing any asset, it’s only worth what someone is willing to pay for it, meaning an investment value is hypothetical. Unlike a business valuation, the investment value varies from investor to investor because it often depends on their own goals.
For example, if Business A has a unique technology that would allow Business B to dominate the competition, the investment value of Business A to Business B would be considerably higher, even if a competing business is bigger but doesn’t have access to this technology.
Likewise, suppose Business B wanted to plunge into the £76.8 billion impact investing market. In that case, they might see Business C as having a higher investment value because what they have better aligns with their medium and long-term goals.
The difference between fair market value and investment value
Fair market value is the estimated price a business or asset would sell for if it were sold today based on the current market. In contrast, investment value is highly personalised because it depends on the specific investor’s goals, strategy, and risk tolerance.
Although there may be disputes over fair market value, most independent business valuation experts will arrive at similar conclusions. On the other hand, investors may have wildly different valuations because of their unique approaches to their investments.
Note that fair market value will often be one of the primary considerations investors incorporate into their investment value.
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How investment value works
Like a standard business valuation, investment valuations can be calculated in any number of ways. Investors often use the same methodologies, including:
Net Present Value (NPV)
Discounted Cash Flow (DCF) method
Although these tried-and-tested methods are deployed, investors can also incorporate other factors. For example, they may look into the intrinsic value of an asset, but they might also weigh it using their personal investment strategy.
That’s why investment value is part science and part preference. An investor may pay more than fair market value because they covet the asset to a greater degree. Likewise, they might pay less than the fair market value because they believe an investment will play into a broader strategy.
The importance of valuation in investment decisions
All parties in an M&A transaction must be aware of the presence of the investment valuation because it increases understanding and supports healthy negotiations.
From an investment point of view, knowing this number helps compare an asset's potential price/value with the expected rate of return. It also helps to determine the element of risk. In short, it allows investors to make intelligent decisions; and investors that make the right decision with the help of an investment valuation are more likely to make a substantial return on their next venture.
From the seller’s point of view, if they already know the investor’s motivations, they can also calculate an investment valuation to understand more about how much the buyer is willing to pay. That allows a departing managing director to maximise their gains.
How to calculate investment value
Before making any investment decision, knowing how to calculate investment value is critical. The truth is there are any number of valuation methods that can be used. Often, it depends on the industry and the type of asset, but it’s wise to use several methodologies to find a baseline.
Here are the most common methodologies you can use.
Comparable sales
Comparable sales analyse assets based on recent similar sales. If you’re buying a house, you’d naturally look at Zoopla to determine what other houses have sold for in your area. The same principle applies to businesses and other assets.
The obvious downside of this method is that you may not have enough similar transactions from which to draw a reference point.
Direct capitalisation
Direct capitalisation relies on taking the net operating income of a business and dividing it by a capitalisation rate. Again, it’s a relatively easy formula to follow, but it relies on comparable sales data to use. That’s why direct capitalisation may be used simultaneously with the comparable sales approach.
Cash on cash return
Cash on cash return calculates how much income an investor might generate from the cash invested in an asset. In most cases, this is a property, but it can also be applied to other assets.
Calculating the cash on cash return involves dividing the business’s annual pre-tax cash flow by how much cash you’re investing. The answer provides information on any cash distributions that might be received if they decide to invest.
Discounted cash flow
The Discounted Cash Flow (DCF) approach forecasts future cash flows to determine the value of a business or other asset.
All you have to do is work out the cash flow for a specific year, including any projected cash flows, and divide by one plus the discount rate.
Net present value
The Net Present Value (NPV) of an asset measures the difference between incomings and outgoings over a period of time. The formula looks like this:
NPV = TVECF – TVIC
TVECF stands for today’s expected cash flows, and TVIC is the value of invested cash today. Generally, if the NPV is negative, it’s an investment to avoid.
Regardless of which method an investor might use to calculate the value of an investment, working with an experienced business broker is the best way to get accurate numbers. Whether buying or selling a business, Hilton Smythe provides access to the industry experts who will get your transaction over the line.
If you’re ready to invest – or you’re dealing with investors – assemble the team that empowers you to maximise value. To learn more, contact Hilton Smythe today.