Value in Use

Value in Use is the net present value of the future cash flows expected to be derived from an asset or a group of assets. Think of it as an asset's worth based on its continued operation within a specific company, rather than its potential selling price on the open market. This concept is fundamentally “entity-specific,” meaning it reflects the value a particular owner can squeeze out of an asset using their unique strategy, technology, and business model. It answers the question, “What is this asset worth to us if we keep using it as planned?” This is a cornerstone of accounting standards like IAS 36 (Impairment of Assets), which uses it as a key test. For a value investor, this perspective is gold. It forces you to think like a business owner, focusing on an asset's productive capacity and long-term earning power, which is the very essence of calculating Intrinsic Value.

Imagine you own a small, local pizzeria with a secret family recipe. Your old, custom-built brick oven is the heart of your operation. It's perfectly seasoned and produces a unique crust that customers love.

• Its Fair Value: If you tried to sell this oven, you might get very little. It’s old, bulky, and not a standard model. A potential buyer might just offer you its scrap metal value. This is its “fair value”—what a willing buyer would pay a willing seller in an open market transaction.
• Its Value in Use: To you, that oven is priceless. It's the engine of your profits, the source of your competitive advantage. The future profits you'll generate from pizzas baked in that specific oven are enormous. This projected stream of cash is its “value in use.”

For your pizzeria, the value in use of the oven is far higher than its fair value. This principle applies to all business assets, from a proprietary software algorithm to a specialized manufacturing plant. The value is determined by its role in the company's grand plan.

Calculating value in use isn't guesswork; it’s a disciplined estimation process using a method called Discounted Cash Flow (DCF). While the math can get complex, the logic is straightforward and built on three key steps:

1. 1. Estimate Future Cash Inflows and Outflows: Management must project all the future cash the asset is expected to generate over its remaining Useful Life. This includes revenues from products made with the asset, less any future costs required to maintain and operate it (e.g., maintenance, raw materials).
2. 2. Determine an Appropriate Discount Rate: A euro today is worth more than a euro in five years, due to inflation and investment opportunity cost. This is the Time Value of Money. The discount rate is a percentage used to shrink future cash flows back to their equivalent value today. A higher rate is used for riskier, less certain cash flows.
3. 3. Sum the Discounted Cash Flows: Each year's projected net cash flow is discounted back to its present value. These are all added up to arrive at a single number—the value in use.

Formula in a Nutshell: Value in Use = (Cash Flow Year 1 / (1 + Discount Rate)^1) + (Cash Flow Year 2 / (1 + Discount Rate)^2) + …

Confusing these two terms is a common mistake, but for an investor, the difference is critical. It's the difference between an owner's perspective and a seller's perspective.

• Perspective: Internal and entity-specific.
• Basis: How the company plans to use the asset.
• Key Question: What is this asset's economic contribution to our business over time?
• Example: A patented drug's value to the pharmaceutical company that owns it, based on projected sales.

• Perspective: External and market-based.
• Basis: What the asset could be sold for in an orderly transaction.
• Key Question: What would someone else pay for this asset today?
• Example: The price another drug company would pay to acquire the patent for that same drug.

Under accounting rules, if an asset's carrying amount (its Book Value) on the balance sheet is higher than both its value in use and its fair value, the company must recognize an Impairment loss. This means the company officially admits the asset is no longer worth what they said it was.

As a follower of Benjamin Graham or Warren Buffett, thinking in terms of “value in use” is your natural state. You don't buy a stock; you buy a piece of a business. Your goal is to estimate the present value of all the cash that business will generate for its owners over its lifetime. That, in essence, is the “value in use” of the entire enterprise. When you see a company take a large impairment charge, it's a signal that their previous “value in use” calculation was too optimistic. This can be a red flag. However, it can also create opportunity. Sometimes, the market, personified by the emotional Mr. Market, overreacts to such news, pushing the stock price far below even the newly revised, more conservative value in use. By focusing on the business's long-term earning power—its value in use—you can remain rational and identify wonderful businesses at fair prices, regardless of Wall Street's short-term panic.