In the market of finance, the term intrinsic value can have two distinct meanings:
- Intrinsic value, is the difference between the strike price of the option and the underlying assets value.
- Intrinsic value is also referred to as the ‘real’ or ‘true’ value of a company. This holds true in regards to the perception of the investors.
The value of the asset is based upon: Growth potentials, cash flows, and associated risks. To estimate intrinsic value, the discounted cash flow approach is mostly used. Under this approach, the predicted cash flows on the assets are discounted back to a rate that indicates the risks of these cash flows.
To understand the concept of what an intrinsic value is, let’s look at the example below: Company ABC currently sells stock at $50 per share. It introduced a new product line with a new look and packaging. They also hired a couple of new managers who previously worked for a rival firm. Now, these changes do not appear on the financial statements, but they help to improve Company ABC’s competitive advantage. Therefore, the investors may calculate the ‘intrinsic value’ at a higher rate; say $70 per share, or $20 more than the current selling value.
Hence, there is no one intrinsic value for a stock at any given time. Investors may vary it according to the market conditions, or by calculating the margin of safety.
Calculating intrinsic value:
When valuing options, the formula below is mostly used:
The intrinsic value (options) = (Price of stock – Strike price) x the number of options
How does intrinsic value matter?
The concept of intrinsic value can help to distinguish between growth and value investors. In the former case, the investors rely on money/earnings that can be too high, too low, or unpredictable. However, in the latter case, the investor only buys stocks selling at the rate of the intrinsic value, and wait for the fair value to be realized.
Intrinsic value also takes into consideration the value of intangible assets of the company. For this reason, the investors need to evaluate some factors that will point out indicators that can affect the stock negatively. Companies dominated by intangible assets like technology will usually face a different market and intrinsic values.
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