Intrinsic value vs Instrumental value – in a financial context

Intrinsic vs Instrumental value are usually discussed in a philosophical context, let’s discuss them in a financial context.

The concept

Intrinsic value in a philosophical context is something that is valuable by itself – like health, friendship etc. In a financial context, something has intrinsic value when it is generating profits and is reasonably expected to continue to do so.

Instrumental value is a philosophical context is something that is valuable because it is a means to an end – for instance money. Instrumental value in the financial context is similar- things have instrumental value as they can help buy something but have no value on their own as they cannot generate profits – for example gold & currency.

In real life things are a bit complex:

Intrinsic Value Instrumental value
Land used in agriculture or construction (generating profits or rents) Land not used in agriculture or construction (not generating profits or rents)
Money in a bank generating interest Money in a locker or under a mattress

Increase in value

Human enterprise can significantly enhance the intrinsic value of things. A given piece of land managed by farmers with different levels of skill and dedication will have different outcomes. In the business world there are a lot of examples, for instance Apple before and after Steve Jobs took over as the CEO, for the second time.

Instrumental value of something will be usually dependent on demand & supply situation (greater the demand the higher the valuation), general state of the economy (when the economy is doing well the value might appreciate). For a large part instrumental value going up is matter of chance.

For investors profits are a result of increase in value. This could be an increase in intrinsic value (that can be enhanced by human enterprise) or this could be increase in instrumental value (that could be based on many external factors a.k.a luck).

Valuation

Valuation deals with a certain level of uncertainty as it involves prediction of the future.  As the Nobel laureate Neils Bohr said “Prediction is very difficult, especially if it’s about the future”

Intrinsic value of something can be calculated by finding out the current value of all the expected future profits (fundamental principle of valuation, you can also refer to our post 3W’s of valuation).

Valuation of things of instrumental value is for a large part speculation. Fortunes have been made and lost in the history of mankind when people spent more time speculating than using their enterprise to generate value. For instance the Tulip mania where tulips became highly prized, Dotcom bubble where “eye-balls” became more important the profits, subprime crisis – where houses were expected to appreciate in value irrespective of their ability to generate/save rents.

Investment vs speculation

Speculation usually leads to transfer of wealth than creation of wealth – it is a zero sum game. Transfers of wealth usually leave some people very well off and many people worse off. Value creation through human enterprise on the other hand leaves every one better off – for instance we can say world is a better place because of Edison, Bill Gates, Steve Jobs etc.

Investment (increase in intrinsic value) Speculation (increase in instrument value)
A person investing in a business with the belief that the management is good and will improve the profitability is betting on an increase in intrinsic value. A person investing in a business with the belief that the business will become the next fad is betting on an increase in instrumental value of the business.
Buying land or property expecting to have a greater yield in crop or rent due to better utilization is betting on the intrinsic value. Buying land or property expecting the prices to go up over a period of time (for any number of reasons other than increased yield or rent) is betting on the increase in instrumental value.

Summary

We just have to remember that expecting increase in value due to a deliberate act of creating value is investment, whereas expecting an increase in value due to circumstance is speculation. Both investment and speculation can make or lose money as they are both bets on the future – but it is best to understand the difference.

We believe that having a good understanding of whether one is betting on an increase in intrinsic value or instrumental value will help investors make more prudent choices and/or accept the outcomes of their choices with a greater equanimity.

 

Happy investing….


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About Praveen Reddy

http://in.linkedin.com/in/praveenreddyinduswealth

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