What Is Intrinsic Value?
Intrinsic value is the perceived or calculated value of an asset, an investment, or a company. Intrinsic value is used in fundamental analysis to value a company and its cash flows. Also, intrinsic value is the amount of profit that exists in an options contract.
Intrinsic Value Explained
Intrinsic value is an umbrella term to estimate the value of an investment, asset, project, or a company. If an analyst or investor is calculating the intrinsic value of a company or the value of its stock price, there are a couple of ways of approaching it.
Intrinsic value can be calculated using fundamental analysis to look at aspects of a business that include both qualitative (business model, governance, and target market factors) and quantitative (financial ratios and financial statement analysis). The resulting value is compared to the market value to determine whether the business or asset is over- or undervalued.
Intrinsic value uses assumptions, and the result is somewhat subjective. Some analysts and investors might place a higher weighting on a corporation's management team while others might view earnings and revenue as the gold standard. For example, a company might have steady profits, but the management has violated the law or government regulations, the stock price would likely decline. By performing an analysis of the company's financials, however, the findings might show that the company is undervalued. Typically, investors try to use both qualitative and quantitative to measure the intrinsic value of a company, but investors should keep in mind that the result is still only an estimate.
- Intrinsic value is the perceived or calculated value of an asset, an investment, or a company.
- Intrinsic value is used in fundamental analysis to value a company and its cash flows.
- Intrinsic value is also the amount of profit that exists in an options contract.
Intrinsic Value of a Company
The discounted cash flow (DCF) model is a commonly used valuation method to determine a company's intrinsic value. The DCF model uses a company's free cash flow and the weighted average cost of capital (WACC), which accounts for the time value of money, and then discounts all its future cash flow back to the present day. The weighted-average cost of capital is the expected rate of return that investors want to earn that's above the company's cost of capital. A company raises capital or funding through issuing debt such as bonds and equity such as stock shares. The DCF model also estimates the future revenue streams that might be received from a project or investment in a company. Ideally, the rate of return and intrinsic value should be above the company's cost of capital.
The future cash flows are discounted meaning the risk-free rate of return that could be earned instead of pursuing the project or investment is factored into the equation. In other words, the return on the investment must be greater than the risk-free rate. Otherwise, the project wouldn't be worth pursuing since there might the risk of a loss. A U.S. Treasury yield is typically used as the risk-free rate, which can also be called the discount rate.
A market risk element is also estimated in many quantitative models. For stocks, the risk is measured by beta, which is an estimation of how much the stock price could fluctuate or its volatility. A beta of one is considered neutral or is 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 a greater return from the cash flows to compensate for the increased risks as compared to an investment with a low beta.
As we can see, calculating the intrinsic value of a company involves various factors some of which are estimations and assumptions. An investor using qualitative analysis can't really know how effective a management team will be or whether they might have a scandal in the near future. Also, using quantitative measures for determining intrinsic value might understate the market risk involved in a company or overestimate the expected revenue or cash flows. What if a new product launch for a company didn't go as planned? The expected future cash flows would undoubtedly be lower than the original estimates making the intrinsic value of the company much lower than had previously been determined.
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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. For review, an options contract gives the buyer the right, but not the obligation, to buy or sell an underlying security, stock, or asset at a preset price called the strike price. Options have expiration dates at which they can be exercised or converted to the shares of the underlying security. A call option allows an investor to buy a security such as a stock while a put option allows an investor to sell a stock. If the market price at expiration is above the strike price, the call option is profitable or in-the-money. If the market price is below the strike of the put option, the put is profitable. If either option is not profitable at expiry, the options expire worthless, and the buyer loses the up-front fee or premium paid at the onset.
The intrinsic value of both call and put options is the difference between the underlying stock's price and the strike price. In the case of both call and put options, 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 can determine the value of an option and its resulting premium. The extrinsic value take into account other external factors that affect an option's price, such as how much time is remaining until expiration or time value. 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 is 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
Intrinsic Value of Options Examples
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 or the $25 stock price minus the $15 strike price. If the option premium paid at the onset of the trade was $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 would be calculated by taking the $20 strike price and subtracting the $16 stock price or $4 in-the-money. If the intrinsic value of the option was only worth $4 at expiry, combined with the premium paid of $5, the investor would have a loss despite the option being in-the-money.
It's important to note the intrinsic value does not include the premium meaning it's not the true profit of 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.