Intrinsic Value Explained

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Free Trading Education!
    Free Demo Account!
    Perfect for Beginners!

  • Binomo
    Binomo

    2 place in the ranking!

Intrinsic Value

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, rather than using the currently trading market price of that asset.

In financial analysis this term is used in conjunction with the work of identifying, as nearly as possible, the underlying value of a company and its cash flow. In options pricing it refers to the difference between the strike price of the option and the current price of the underlying asset.

Intrinsic Value

Intrinsic Value Explained

Intrinsic value is an umbrella term with useful meanings in several areas. Most often the term implies the work of a financial analyst who attempts to estimate an asset’s intrinsic value through the use of fundamental and technical analysis.

There is no universal standard for calculating the intrinsic value of a company, but financial analysts build valuation models based on aspects of a business that include qualitative, quantitative and perceptual factors.

Qualitative factors—such as business model, governance, and target markets—are those items specific to the what the business does. Quantitative factors found in fundamental analysis include financial ratios and financial statement analysis. These factors refer to the measures of how well the business performs. Perceptual factors seek to capture investors perceptions of the relative worth of an asset. These factors are largely accounted for by means of technical analysis.

Creating an effective mathematical model for weighing these factors is the bread and butter work of a financial analyst. The analyst must use a variety of assumptions and attempt to reduce subjective measures as much as possible. In the end, however, any such estimation is at least partly subjective. The analyst compares the value derived by this model to the asset’s current market price to determine whether the asset is overvalued or undervalued.

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.

Key Takeaways

  • In financial analysis, intrinsic value is the calculation of an asset’s worth based on a financial model.
  • Analysts often use fundamental and technical analysis to account for qualitative, quantitative and perceptual factors in their models.
  • In options trading, intrinsic value is the difference between the current price of an asset and the strike price of the option.

Discounted Cash Flow and Intrinsic Value

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). WACC 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 funding by issuing debt such as bonds and equity or 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 be a 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.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Free Trading Education!
    Free Demo Account!
    Perfect for Beginners!

  • Binomo
    Binomo

    2 place in the ranking!

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.

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 know how effective a management team will be or whether they might have a scandal in the near future. Using quantitative measures for determining intrinsic value might understate the market risk involved in a company or overestimate the expected revenue or cash flows. Additionally, depending on the current market environment, investors may perceive greater or lesser benefit to holding the shares in the months ahead, so this should also be factored into any model.

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.

Intrinsic value is a core concept of value investors seeking to uncover hidden investment opportunities. To calculate intrinsic value, you need to have a strong understanding of fundamental analysis. Investopedia’s Fundamental Analysis Course will show you how to calculate the true value of a stock and capitalize on undervalued opportunities. You’ll learn how to read financial statements, use ratios to determine value quickly, as well as learn other techniques used by professionals in over five hours of on-demand videos, exercises, and interactive content.

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 grants the buyer the right, but not the commitment, to buy or sell the underlying security 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 assets such as a stock while a put option allows an investor to sell the asset. 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 worthlessly, and the buyer loses the upfront 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 takes 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 an impact on 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.

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 or the $25 stock price minus the $15 strike price. 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 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 were 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.

Intrinsic Value vs. Current Market Value: What’s the Difference?

Intrinsic Value vs. Current Market Value: An Overview

There is a significant difference between intrinsic value and market value, though both are ways of valuing a company. Intrinsic value is an estimate of the actual true value of a company, regardless of market value.

Market value is the current value of a company as reflected by the company’s stock price. Therefore, market value may be significantly higher or lower than the intrinsic value. Market value is also commonly used to refer to the market capitalization of a publicly-traded company and is obtained by multiplying the number of its outstanding shares by the current share price.

Intrinsic Value

Intrinsic value is a core metric used by value investors to analyze a company. The idea is that it is best to invest in companies that have a higher true value than the one being assigned to it by the market. Intrinsic value is a type of fundamental analysis. Tangible and intangible factors are considered when setting the value, including financial statements, market analysis, and the company’s business plan.

There is an inherent degree of difficulty in arriving at a company’s intrinsic value. Due to all the possible variables involved, such as the value of the company’s intangible assets, estimates of the genuine value of a company can vary greatly between analysts.

Some analysts utilize discounted cash flow analysis to include future earnings in the calculation, while others look purely at the current liquidation value or book value as shown on the company’s most recent balance sheet. Further, difficulty arises from the fact that the balance sheet itself since it is an internally produced company document and may not be a completely accurate representation of assets and liabilities.

Market Value

Market value is the company’s value calculated from its current stock price and rarely reflects the actual current value of a company. Market value is, instead, almost more of a measure of public sentiment about a company. The reason for this is that the market value reflects supply and demand in the investing market, how eager (or not) investors are to participate in the company’s future. Another difficult factor in determining market value is how to value illiquid assets such as real estate and business lines.

The market value is usually higher than the intrinsic value if there is strong investment demand, leading to possible overvaluation. The opposite is true if there is weak investment demand, which can result in the undervaluation of the company.

Intrinsic Value Formula

Table of Contents

What is an Intrinsic Value Formula?

The formula for Intrinsic value basically represents the net present value of all the future free cash flows to equity (FCFE) of a company during the entire course of its existence. It is the reflection of the actual worth of the business underlying the stock i.e. the amount of money that can be received if the whole business and all of its assets are sold off today.

Intrinsic value Formula

Intrinsic value formula for business and stock is represented as follows –

#1 – Intrinsic Value Formula of a Business

Mathematically, the intrinsic value formula of a business can be represented as,

  • where FCFEi = Free cash flow to equity in the i th year
  • FCFEi = Net income i + Depreciation & Amortisation i – Increase in Working Capital i – Increase in Capital Expenditure i – Debt Repayment on existing debt i + Fresh Debt raised i
  • r = Discount rate
  • n = Last projected year

#2 – Intrinsic Value Formula of a Stock

The calculation of intrinsic value formula of stock is done by dividing the value of the business by the number of outstanding shares of the company in the market. The value of stock derived in this way is then compared with the market price of the stock to check if the stock is trading above / at par / below its intrinsic value.

Intrinsic Value Formula Stock = Intrinsic Value Business / No. of outstanding shares

Explanation of the Intrinsic Value Formula

The calculation of formula of the intrinsic value of a stock can be done by using the following steps:

Step 1: Firstly, determine the future FCFE for all the projected years based on the available financial plan. The projected FCFEs can be computed by taking the latest FCFE and multiply it with the expected growth rate.

Step 2: Now, the discount rate is determined based on the current market return from an investment with similar risk profile. The discount rate is denoted by r.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Free Trading Education!
    Free Demo Account!
    Perfect for Beginners!

  • Binomo
    Binomo

    2 place in the ranking!

Like this post? Please share to your friends:
Binary Options Online Trading
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: