What Is Intrinsic Value?
Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an objective calculation or complex financial model. Intrinsic value is different from the current market price of an asset. However, comparing it to that current price can give investors an idea of whether the asset is undervalued or overvalued.
Financial analysis uses cash flow to determine the intrinsic, or underlying, value of a company or stock. In options pricing, intrinsic value is the difference between the strike price of the option and the current market price of the underlying asset.
- There are various ways to calculate intrinsic, or true, value.
- Discounted cash flow analysis is used for many intrinsic value calculations.
- Intrinsic value is a core concept that value investors use to uncover hidden investment opportunities.
- In options trading, intrinsic value is the difference between the current price of an asset and the strike price of the option.
- When an asset's market price is below its intrinsic value, it may be a smart investment.
Understanding Intrinsic Value
There is no universal standard for calculating the intrinsic value of a company or stock. Financial analysts attempt to determine an asset's intrinsic value by using fundamental and technical analyses to gauge its actual financial performance.
While they may build valuation models using qualitative, quantitative and perceptual business factors, the metric often used in calculations for intrinsic value is discounted cash flows.
Typically, investors try to use both qualitative and quantitative factors to measure the intrinsic value of a company, but investors should keep in mind that the result is still only an estimate.
Qualitative factors are such things as business model, governance, and target markets—items specific to the what the business does. Quantitative factors refer to financial performance and include financial ratios and financial statement analysis. Perceptual factors refer to investors' perceptions of the relative worth of an asset. They're largely accounted for by means of technical analysis.
Generally speaking, intrinsic value can be considered to be how much the business is worth, as determined by selling off the whole business and its assets.
How to Calculate Intrinsic Value
Using discounted cash flow (DCF) analysis, cash flows are estimated based on how a business may perform in the future. Those cash flows are then discounted to today’s value to obtain the company's intrinsic value. The discount rate used is often a risk-free rate of return, such as that of the 30-year Treasury bond. It can also be the company's weighted average cost of capital (WAAC).
Discounted cash flow formula
DCF = CF1/(1+r)1 + CF2/(1+r)2 + . . . + TV/(1+r)n
CF = the expected cash flow for a specific period (e.g., CF1 = cash flow year one)
r = the discount rate
TV = the terminal value (estimated cash flow after the projection period)
n = the specific period (e.g., years, quarters, months, etc.)
As an example, let's use the earnings available to investors from our Acme Bolt Company as cash flow. Say this figure is $200 (after adding depreciation and subtracting capital expenditures) for the latest year. If a hypothetical P/E multiple for the S&P 500 is 15, Acme's per share market value is $3,000 (15 x $200). We'll use that figure for the comparison to intrinsic value.
Using an estimated growth rate of 7%, the estimated cash flow for each of 10 years is:
- Year 1: $214.00 (200 x 1.07)
- Year 2: $228.98 (200 x 1.072)
- Year 3: $245.00 (200 x 1.073 and so forth)
- Year 4: $262.16
- Year 5: $280.51
- Year 6: $300.15
- Year 7: $321.16
- Year 8: $343.64
- Year 9: $367.70
- Year 10: $393.43
Next, we discount these cash flows using a theoretical 30-year T-Bond rate of 3.3%. We apply it using the discounted cash flow formula (shown above) for each year. For example, the formula for the first year is CF/1 + r. The discounted cash flow for each of 10 years is:
- Year 1: $207.16 (214/1.033)
- Year 2: $214.58 (228.98/1.0332)
- Year 3: $222.26 (245/1.0333 and so forth)
- Year 4: $230.23
- Year 5: $238.48
- Year 6: $247.02
- Year 7: $255.87
- Year 8: $265.03
- Year 9: $274.53
- Year 10: 284.35
The total discounted cash flow is $2439.51.
Then, a quick and common way to estimate the terminal value is to multiply the earnings in the final year of the projection period by a multiple of 15. That's $393.43 X 15 = $5897.10. That amount discounted is $4262.21 (5897.10/1.03310).
Finally, combine the first 10 years of discounted cash flows with the terminal cash flow for the intrinsic value:
$2439.51 + $4262.21 = $6703.72
Compared to Acme's current share price of $3000, the intrinsic value of $6701.72 indicates the stock is undervalued and is worth considering as an investment.
Market Risk and Intrinsic Value
A market risk element is also estimated in many valuation models. For stocks, the risk is measured by beta—an estimation of how much the stock price could fluctuate or its volatility.
A beta of one is considered neutral or correlated with the overall market. A beta greater than one means a stock has an increased risk of volatility while a beta of less than one means it has less risk than the overall market. If a stock has a high beta, there should be greater return from the cash flows to compensate for the increased risks as compared to an investment with a low beta.
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Intrinsic Value of Options Contracts
Intrinsic value is also used in options pricing to determine how in-the-money an option is or how much profit currently exists.
To review, an options contract grants the buyer the right, but not the obligation, to buy or sell the underlying security at a preset price called the strike price. Options have expiration dates by which they must be exercised or converted to the shares of the underlying security.
The intrinsic value of both call and put options is the difference between the underlying stock's price and the strike price. If the calculated value is negative, the intrinsic value is zero. In other words, intrinsic value only measures the profit as determined by the difference between the option's strike price and market price.
However, other factors such as extrinsic value can affect the value of an option and its resulting premium. It takes into account other external factors such as how much time is remaining until expiration.
If an option has no intrinsic value, meaning the strike price and the market price are equal, it might still have extrinsic value if there's enough time left before expiration to make a profit.
As a result, the amount of time value that an option has can impact an option's premium. Both intrinsic value and extrinsic value combine to make up the total value of an option's price.
Intrinsic value helps determine the value of an asset, an investment, or a company.
Intrinsic value provides the amount of profit that exists in an options contract.
Calculating the intrinsic value of a company can be subjective since it estimates risk and future cash flows.
The intrinsic value of an option is incomplete since it doesn't include the premium paid and time value.
Example of an Option's Intrinsic Value
Let's say a call option's strike price is $15, and the underlying stock's market price is $25 per share. The intrinsic value of the call option is $10 ($25 minus $15). If the option premium paid at the onset of the trade were $2, the total profit would be $8 if the intrinsic value was $10 at expiry.
On the other hand, let's say an investor purchases a put option with a strike price of $20 for a $5 premium when the underlying stock was trading at $16 per share. The intrinsic value of the put option is the $20 strike price less the $16 stock price, or $4 in-the-money.
An intrinsic value of $4 at expiry combined with the premium paid of $5 means the investor has a loss despite the option being in-the-money.
It's important to note that the intrinsic value does not include the premium. It's not the same as the actual profit on the trade since it doesn't include the initial cost. Intrinsic value only shows how in-the-money an option is, considering its strike price and the market price of the underlying asset.
Why Is Intrinsic Value Useful to Know?
It's useful because it can help an investor understand whether a potential investment is overvalued or undervalued. Meaning, if the market price of stock of a particular company is currently $125 and the intrinsic—or true— value is calculated at $118, then an investor may decide the stock is too expensive at this time and not worth purchasing.
What's the Difference Between Market Value and Intrinsic Value?
Market value equates to the current price of a particular asset. For example, the market price of a share of ABC Company stock may be $50 as of yesterday's market close. It may have a market price (value) of $55 at some point today, depending on buying interest. However, intrinsic value is the true value of the company, as determined using a valuation model.
Is Intrinsic Value Better Than Market Value for Investing?
Some people believe it is. Market value is determined by what people are willing to buy an asset for, based on any number of reasons. These might include someone's financial needs, short-term trading goals, and trading impulses. On the other hand, intrinsic value measures the value of an investment based on specific information about it, such as its cash flows and its actual financial performance.
The Bottom Line
Knowing how to calculate intrinsic value is useful for investors trying to get at an investment's true value. That's because intrinsic value is based on future cash flows, not simply where an investment may be trading currently.
Value investors in particular seek to know intrinsic value because it helps them understand whether an investment is appropriately priced, according to their investing approach. Since knowing intrinsic value is considered fundamental to analyzing securities, it's a good idea for investors to understand how to calculate it.