In Finance, what is an Embedded Value?

Embedded value, or EV, is a type of valuation measure that is sometimes used by insurance companies in various parts of the world. The EV normally focuses on the current value of the future profits of the insurance company, plus any adjusted net asset value or book value that the business current possesses. While rarely employed in North America, this type of accounting method is in common use in many parts of Europe, the Orient, and some countries in Africa. Considered a somewhat conservative approach, calculating embedded value often requires omitting some factors that other methods require as part of the equation.

One of the distinguishing characteristics of the embedded value approach is that some types of goodwill are omitted from consideration. Goodwill often includes intangible factors that provide a positive influence on the business, but do not represent a specific monetary value. The type of goodwill that may be excluded from consideration may be the positive attitude of the employees, the presence of strong and effective leadership by management, or the fact that the business operates from a physical location that is highly desirable and strategic.

Along with the omission of goodwill factors, the calculation of the embedded value does not address the possibility of the generation of new business in the future. This is based on the assumption that any new business generated would not accomplish much more than offsetting any loss of accounts that may take place during the years, effectively allowing the company to maintain but not post any real growth. In many situations, the use of this particular valuation method will produce a figure that is less than the actual market value of the business.

One of the benefits of using this conservative approach of embedded value is that the business is much more likely to operate within a budget that can keep the company afloat during periods when sales are down. Since the formula excludes any revenue that is generated by securing new customers that create a sales volume greater than the present day figure, a company using this method could maintain even if it generated no sales at all for a given period. At the same time, any additional sales to new customers simply add to the surplus generated by the company, and increase the financial stability of the operation. That surplus can then be used for expansion projects or in some other manner that ultimately benefits the company, without having any real impact on the operating budget.