Intrinsic worth method of Purchase Consideration.

Intrinsic Worth Method of Purchase Consideration

1. Definition:

• The intrinsic worth method of purchase consideration is a method used in business acquisitions to determine the fair value of the target company based on its intrinsic value. Intrinsic value is the perceived or calculated value of an asset, investment, or company based on fundamental analysis rather than market value.

2. Calculation of Intrinsic Worth:

• The intrinsic worth of a target company is calculated based on its future cash flows, growth potential, risk factors, and other relevant financial metrics. It involves projecting the target company's future earnings and cash flows and discounting them back to present value using an appropriate discount rate.

3. Discounted Cash Flow (DCF) Analysis:

• The most common method used to calculate the intrinsic worth of a target company is the discounted cash flow (DCF) analysis. In this method, the future cash flows of the target company are estimated for a certain period, usually five to ten years, and then discounted back to present value using a discount rate that reflects the riskiness of the cash flows.

4. Factors Considered in DCF Analysis:

• Future Cash Flows: The projected future cash flows of the target company are the key input in the DCF analysis. These cash flows are based on the company's historical performance, growth prospects, industry trends, and other relevant factors.
• Discount Rate: The discount rate used in the DCF analysis is a critical factor that reflects the riskiness of the target company's cash flows. The discount rate is typically based on the company's cost of capital, which includes the cost of debt and equity.

5. Advantages of Intrinsic Worth Method:

• Long-Term Perspective: The intrinsic worth method takes a long-term perspective by focusing on the target company's future cash flows and growth potential rather than short-term market fluctuations.
• Fundamental Analysis: The method is based on fundamental analysis, which considers the underlying factors that drive the target company's value, such as its competitive position, industry dynamics, and management quality.
• Customization: The intrinsic worth method allows for customization based on the specific characteristics of the target company and its industry, making it more precise and reliable than other methods.

6. Limitations of Intrinsic Worth Method:

• Subjectivity: The intrinsic worth method relies on subjective assumptions and estimates, such as future cash flows and discount rates, which can vary widely among analysts.
• Complexity: The method can be complex and time-consuming, requiring detailed financial analysis and projections that may be difficult to validate.
• Sensitivity to Inputs: The intrinsic worth method is sensitive to changes in key inputs, such as growth rates and discount rates, which can significantly impact the calculated intrinsic worth.

7. Conclusion:

• The intrinsic worth method of purchase consideration is a valuable tool for determining the fair value of a target company based on its fundamental value and long-term prospects. While the method has its limitations, it provides a comprehensive and customized approach to valuing a target company, which can be useful in making informed acquisition decisions.