Intrinsic value definition
Intrinsic value (often called fundamental value) is an estimation of an asset’s worth based on a financial model. The term often refers to the work of financial analysts who evaluate what they deem to be the intrinsic value of a particular stock outside of its perceived market price on any given day. These evaluations are done through fundamental and technical analysis and include several methods to account for qualitative, quantitative, and perceptual factors. The disparity between market price and an analyst’s calculated intrinsic value can be a useful measure of investing opportunity. Knowing an investment’s intrinsic value is especially helpful to value investors with the goal of purchasing stocks or other assets at a discount. Intrinsic value is also utilized in options pricing. The intrinsic value, then, referring the difference between the current market price of an underlying asset and the exercise price of an option. Related reads:What is Value Investing?What is Momentum Investing?17 Common Investing Mistakes to AvoidHow to Buy and Sell Stocks?10 Best Stock Trading Books for Beginners15 Top-Rated Investment Books of All Time
Why does intrinsic value matter?
Intrinsic value is an essential metric for investors to recognize when stocks are undervalued or trading below their true worth, which usually signifies a profitable investment opportunity. Conversely, if the stock price is higher than the intrinsic value, it may be overvalued and not worth buying (but potentially worth shorting). Understanding the notion of intrinsic value and the various strategies you can use to estimate it can help you make well-informed investment decisions. Estimating intrinsic value can be particularly crucial when dealing with IPOs (initial public offerings) or young, high-growth companies, specifically those companies known as “industry disruptors,” which have the potential but are not yet recognized by Wall Street analysts. Most investors believe that the price of a stock will ultimately move towards its intrinsic value over time. However, the stock price is unlikely to stay at its intrinsic value for long. Instead, the stock price will generally oscillate around the intrinsic value. Therefore, traders who use this concept typically prefer to invest when the stock is trading below its intrinsic value and subsequently sell when it is above.
How to calculate intrinsic value?
There is no universal measure for estimating the intrinsic value of a business. However, financial analysts build valuation models based on aspects of a company that includes qualitative, quantitative, and perceptual factors. Qualitative factors are items characteristic of what the company does, such as business model, governance, and target markets. Quantitative factors found in the fundamental analysis contain financial ratios and financial statement analysis, referring to the measures of how well the company performs. Finally, perceptual factors seek to capture investors’ perceptions of the relative worth of an asset. These factors are primarily accounted for by utilizing technical analysis. To calculate the intrinsic value of a stock, a financial analyst will:
Use various methods to get the most accurate result of a company’s value; Establish whether the asset is overvalued or undervalued by comparing the value derived from the analysis to the asset’s current market price. Still, any such estimation will be at least partly subjective;
For example, a company might have stable profits, but the stock price would likely decline in the event of a scandal. However, by analyzing the company’s financials, the findings might show that the company is undervalued. Importantly, investors should assume that the result is still only an estimate. Next, we will look at some of the most widespread approaches for calculating a company’s intrinsic value.
Discounted cash flow (DCF) model
The discounted cash flow analysis is the most common valuation method to find a stock’s fundamental value. DCF is a valuation method used to forecast the value of an investment based on its projected cash flows. DCF analysis attempts to assess the value of an asset today based on expected revenue streams in the future. The weighted average cost of capital (WACC) is usually used as the discount rate for future cash flows because it considers the rate of return expected by shareholders. The formula is as follows: To perform a DCF analysis, you’ll need to follow three steps:
How Warren Buffet uses DCF?
The world’s most well-known value investor Warren Buffett believes investors should pay less for an asset than its intrinsic worth, recommending the DCF valuation method to approximate whether a stock is attractively valued or not at its current price. Buffet follows the “Margin of Safety” investment principle borrowed from Benjamin Graham and only considers companies trading at a considerable discount (40% or more) to their DCF value. This margin of safety helps ensure reasonable return potential even if some of our assumptions are off. Recommended video: How Warren Buffet Values Stocks
Residual income model
The residual income (income that one continues to receive after completing the income-producing work) model is another valuation method for estimating a company’s intrinsic value. It derives the value of the stock based on the difference in earnings per share and per-share book value (in this case, the security’s residual income) to arrive at the stock’s intrinsic value. The model seeks to find the stock’s intrinsic value by adding its present per-share book value (value of an asset according to the balance sheet) with its discounted residual income. The formula is as follows:
Dividend discount model
When determining a stock’s intrinsic value, cash is king (slang for the belief that money is more valuable than any other form of an asset). Therefore, models used to calculate intrinsic value often factor in variables primarily relating to cash (e.g., dividends and future cash revenues) and employ the time value of money (TVM). For example, a solid model for finding a company’s intrinsic value is the dividend discount model (DDM). One variety of DDM is the Gordon Growth Model (GGM), which assumes the company is within a steady-state, i.e., growing dividends in perpetuity. The formula is as follows: DDM accounts for the dividends that a company pays out to shareholders, which consequently reflects on the company’s ability to generate cash flows. This model has multiple variations, each of which factors in different variables depending on what assumptions you wish to include. The GGM has the most merit when applied to the analysis of blue-chip stocks and broad indices.
Asset-based valuation
The most straightforward way of calculating the intrinsic value of a stock is to use an asset-based valuation. It is calculated by subtracting the sum of a company’s liabilities from the sum of its assets (both tangible and intangible). A disadvantage to using this method is that it does not incorporate any future growth prospects for a company and might often give much lower intrinsic value estimations.
Analysis based on a financial metric
Another uncomplicated way of establishing the intrinsic value of a stock is to use a financial metric such as the price-to-earnings (P/E) ratio. A P/E ratio measures a company’s stock price in relation to its earnings. It can also help tell you whether the price is high or low, compared to other companies in the same sector. Here’s the formula for this method using the P/E ratio of a stock is as follows: Intrinsic value = Earnings per share (EPS) x (1 + r) x P/E ratio where: r = the expected earnings growth rate
Options trading
Intrinsic value is also employed in options pricing. An options contract gives the buyer the right to buy or sell the underlying security. The profitability of each option will depend on the option’s strike price and the underlying stock’s market price at the options’ expiration date. Namely, a call option grants the buyer the right to buy stock, whereas a put option grants the buyer the right to sell stock short. If the market price at expiration is above the strike price, the call option is in the money. If the market price is below the put option’s strike, the put is profitable. If an option is not profitable at expiry, it expires, and the buyer loses the upfront fee or premium paid at the onset. The intrinsic value of a call option is the current price of the stock minus the option’s strike price. The intrinsic value of a put option is the strike price minus the underlying stock’s current price. When the calculated value is negative, the intrinsic value is zero. Therefore, intrinsic value only evaluates the profit as defined by the difference between the option’s strike price and market price. Example: For instance, if a call option’s strike price is $10 and the market price is $30, its intrinsic value is $20 because if it were exercised, its owner could buy the underlying stock for $20 less than its current market price.
Extrinsic vs. intrinsic value in stock options
Nevertheless, other aspects can affect the value of an option, such as extrinsic value, which considers other external factors that determine an option’s price, like how much time remains until expiration or time value. If an option doesn’t have intrinsic value (the exercise price and the market price are equal), it could 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 impacts an option’s premium. Both intrinsic and extrinsic values combine to make up the total value of an option’s price. Extrinsic value is the difference between the market price of an option (premium) and its intrinsic price (the difference between an option’s current price and strike price). The extrinsic value increases with a rise in volatility in the market.
The intrinsic value of commodities and digital assets
Amid the global financial crisis, growing skepticism of banks, and technological innovation, investors are finding new assets to buy and hold, like digital currencies like NFTs and Bitcoin. But, do these assets have intrinsic value? And what about more reputable commodities, such as gold?
Gold
Some people, including legendary value investor Warren Buffett, argue that gold has no intrinsic value, especially as an investment over the long term compared to other more productive assets. However, let’s take intrinsic value to mean the value of gold as a raw material rather than as an investment. Firstly, gold does have intrinsic utility – it is required for specific scientific, medical, and manufacturing operations that are unique to it, so it has a real tangible value that no other element can replace, in addition to its ornamental usage (jewelry). However, that utility doesn’t justify the value people put on it or its market value. Instead, gold’s value is ultimately a social construction. Most of the utility of gold comes from the fact that people think it is valuable and will keep that value. Still, gold’s relative scarcity, the difficulty of extraction, and its luminous and metallic qualities have only added to the belief of gold as a valuable commodity. Moreover, gold can be an asset with various intrinsic qualities that make it unique and necessary for investors to hold in their portfolios. As a global store of value, owning gold can hedge against inflation, be a good portfolio diversifier, and provide financial cover during geopolitical and macroeconomic uncertainty. Finally, it is the metal we turn to when other forms of currency fail, which means it always will have some value as insurance against challenging times.
Bitcoin
Bitcoin (BTC) is often referred to as a digital currency and as an alternative to central bank-controlled fiat currency (government-issued money that isn’t backed by a physical commodity, like gold, but rather by the government that issued it). Part of Bitcoin’s appeal is that Bitcoin’s network is decentralized, i.e., the cryptocurrency is not backed by central banks. But it could also be the very reason why it lacks true worth. Arguably, Bitcoin’s value is similar to that of precious metals, as both are limited in quantity and have unique uses. Like gold, which can be used in industrial processes, Bitcoin’s underlying technology, the blockchain, can be utilized across the financial services industries. In addition, like gold, the primary source of value for Bitcoin is its scarcity, as it’s limited to a quantity of 21 million. Therefore, its value lies in restricted supply and increasing demand. Another theory is that Bitcoin does have intrinsic value based on the marginal expense of producing one Bitcoin, as mining for Bitcoins involves a tremendous amount of electricity, imposing an immense cost on miners. According to economic theory, in a competitive market, the selling price of a product will lean towards its marginal cost of production. And empirical evidence has shown that the price of a Bitcoin tends to follow the cost of production. When it comes to Bitcoin’s value as an investment, some investors have indeed turned to Bitcoin since they view it as uncorrelated with stocks, making it a solid option for diversifying their portfolio. However, since its price is highly volatile, having a lower portfolio allocation to crypto can help boost returns while bolstering from significant losses.
NFTs
Non-fungible tokens (NFTs) are one-of-a-kind cryptographic tokens that exist on a blockchain and cannot be replicated. NFTs were created in 2014 and can digitally represent any asset, including online-only assets like digital artwork, metaverse items like avatars, digital and non-digital collectibles, domain names, and event tickets. NFTs are thought to have hardly any value apart from the cost a consumer is willing to pay for them, precisely because they are not tradable and cannot be exchanged. Consequently, the value of an NFT depends on how much people want to own it and its type. But, of course, these value definitions can be exceptionally subjective, making NFTs’ value fluctuate depending on their scarcity and how much enjoyment people will receive from owning them. When it comes to NFTs, the intrinsic value is the enjoyment that a person gets from knowing they own a certain NFT. Therefore, the more pleasure they think they will get from it, the more they are prepared to pay for the NFT, thus increasing its value.
Pros and cons of intrinsic value
Even though intrinsic value calculation may not be a foolproof method of mitigating all losses to your portfolio, it does provide a more unambiguous indication of a company’s financial health. However, like any evaluation process, it comes with its own set of unique advantages and disadvantages.
In conclusion
Intrinsic value helps investors recognize when stocks are undervalued or trading below their true worth, as well as estimate how a business will evolve, including its growth rate, margins, and investment levels. So, it’s a particularly handy tool for value investors looking to find profitable investment opportunities. However, investors must be careful before using intrinsic value as an analysis metric. While some analysts might undervalue a stock, others may overvalue it. Therefore, each measurement method must be thoroughly scrutinized before being accepted as a valuable decision tool.
