Intrinsic Value

Intrinsic value is a measure that helps investors calculate the worth of an investment or asset. This measure is derived from objective calculation or complex financial models. This value and the current market value of an asset or investment are two completely different measures.

With its help, one can quickly determine if the assets or investments are overvalued or undervalued by comparing the current market value with this.

The financial analyst uses cash flow to determine the intrinsic value of a company or stock. It is also used in option pricing, as options pricing is the difference between the options' strike price and the underlying assets' current market price.

Discounted Cash Flow (DCF) is the primary metric used to determine the intrinsic value of assets or investments. 

Using this method, the value of an asset is derived from the expected future cash flow, which will be discounted later with the rate which shows the risk associated with the purchase or company.

The utilization of intrinsic value and discounted cash flow (DCF) for value investing was pioneered by Benjamin Graham and David Dodd of the Columbia Business School in the 1920s. 

This value investing method was popularized by Warren Buffet, who himself has used this method for a very long time since the 1950s.

Understanding Intrinsic Value

You can still calculate the fee of an enterprise or an asset in multiple ways. Financial analysts commonly determine an asset's price through fundamental and technical evaluation to recognize its overall financial performance.

There are one-of-a-kind approaches to constructing a valuation version. Using qualitative, quantitative, and perceptual business factors simultaneously as the metric regularly used within the calculation for intrinsic value is Discounted coins.

DCF evaluation is a famous method used to determine it. It calculates the current value of all future cash flows that investment is predicted to generate, discounted back to its current fee. 

The buyers use qualitative and quantitative elements to determine the agency's price and remember that the cost is an estimate simplest and would not constitute the asset's actual price.

Qualitative elements which can be used to determine the fee of the asset or organization are:

1. Business Model 

An enterprise version is a qualitative thing that describes how an organization generates revenue and earnings. A sound business version can lead to a sustainable and worthwhile increase, at the same time as a possible fallacious cause of failure.

After analyzing an agency's business model, traders can decide its ability for lengthy-time period fulfillment and have its competitive blessings.

2. Governance 

Governance refers to regulations, practices, and methods by which a company is directed and managed. It is far from an element that may impact an investor's choice to invest in the corporation. 

It could help ensure that a company is managed successfully, ethically, and in the pleasant pursuits of all stakeholders. 

3. Target Market

Target market refers to the organization of customers to whom an enterprise intends to sell its products or services. It is far from a qualitative factor as it enables deciding to call for revenue for a corporation's products or services.

Quantitative elements which might be used are:

1. Financial performance

Financial overall performance is a quantitative factor that refers to an agency's beyond and gift economic consequences. It consists of measures along with sales, profits, cash waft, go back on investment, and other monetary ratios.

Economic overall performance is a crucial issue that helps calculate a funding's price as it offers a brief understanding of the agency's profitability, boom capacity, and economic health.

2. Financial ratios

Financial ratios work as quantitative measures which can be used to assess an enterprise's financial fitness and are considered one of the crucial elements at the same time as figuring out the intrinsic price of a company.

The P/E ratio, P/S ratio, return on equity (ROE), and debt-to-fairness ratio are the most commonly used financial ratios.

3. Financial statement analysis

Financial assertion analysis is a quantitative element of intrinsic cost that involves evaluating an agency's monetary statements to evaluate its economic health and performance. 

It analyzes factors, including revenue growth, profitability, coins float, debt degrees, and asset utilization, to decide the organization's intrinsic value. 

Perceptual elements consult with traders' belief of the worth of the asset or organization.

How to Calculate Intrinsic Value?

To calculate it, assets and the company's Discounted Cash Flow (DCF) will be used, and the cash flow will be the estimate based on the business in the future.

Those cash flows will later be discounted according to today's value to obtain the company's or asset's intrinsic value. Discounted rate used here is usually the risk-free rate of treasury bonds.

Formula, 

DCF = CF1 / (1+r)1 + CF2 / (1+r)2 + … + TV / (1+r)n

Where, 

• DCF: Discounted Cash Flow
• CF: Cash Flow in years
• TV: Terminal Value
• r: The discount Rate

Let us understand this concept with an example: the earning from share A is $100 for the latest year, and the share price is $1,000, making P/E 10 (1,000/100). Then, calculate DCF by using a growth rate of 7% and discounting rate of 3%:

The projection of DCF for five years is as follows:

• Year 1: $103.88 ((100 x 1.07^1) / (1.03)^1)

• Year 2: $112.10 ((103.88 x 1.07^2) / (1.03)^2)

• Year 3: $125.67 ((112.10 x 1.07^3) / (1.03)^3)

• Year 4: $146.35 ((125.67 x 1.07^4) / (1.03)^4)

• Year 5: $170.44 ((146.35 x 1.07^5) / (1.03)^5)

The total discounted Cash flow is $685.44. The terminal value of the share can be calculated by multiplying the final year's earnings by 15. That's $170.44 x 10 = $1,704.4, and the discounted Terminal value is $1,470.23 ($1,704.4 / 1.035).

Now, we have to combine the terminal value and DCF of 5 years, which is:

$685.44 + $1,470.23 = $2,155.67

Thus, the share is undervalued and has the potential to grow as the Intrinsic value ($2,155.67) is more than the market value ($1,000).

Intrinsic Value of Options Contracts

It is also used to determine the profit in the option pricing. An option contract gives the buyer the right to buy or sell the underlying security but not the obligation at a preset price called Strike Price.

These options have an expiration date before which they must be completed or converted into the shares of the securities mentioned under it.

The intrinsic value of the call and put options can be determined by the difference between the stock's price and the strike price of that investment. The Value is Zero when the difference is negative.

It only helps determine the expected profit, calculated by the difference between the option's strike and market prices.

Many other external factors can affect the option's value and resulting premium. For example, factors like time left till expiration are also considered.

When the strike price and the market price are equal, there is no Intrinsic value, and there may be any other external factor driving the option's price.

Both the Intrinsic value and the value from external factors combine to make up the total value of an option's price.

 Researched and authored by Ashish Jangra | Linkedin

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources 

To continue learning and advancing your career, check out these additional helpful WSO resources:

• PEG(Ratio)
• Q Ratio
• Owner's Equity
• Real Options
• Store Of Value