What is intrinsic value?
There are numerous factors involved when assessing the value of any asset. One is its intrinsic value, which can be calculated either through objective analysis or a financial model. Heres how it works. Intrinsic value definition  Intrinsic value is a term that describes what an asset is worth, but this can have slightly different applications. In options pricing, intrinsic value marks the difference between the assets current price and option strike price. In financial analysis, its used to work out a companys underlying value according to the current market. In both cases, it uses a financial model or objective calculation to determine a figure of worth, rather than relying on the assets current trading price. Investors can make decisions based on current stock prices alone, but this doesnt paint the full picture of an assets worth. With intrinsic value, investors are able to determine what the stock is really worth. This is particularly helpful for value investors who seek out undervalued stocks or other discounted investment options. How to calculate intrinsic value  There are several calculation methods to choose from when working out an assets intrinsic value. Discounted cash flow analysis  A discounted cash flow analysis (DCF) dives into a companys cash flows to arrive at intrinsic value. There are three steps involved:  Estimate future cash flows. Calculate the present value of future cash flows. Analyse present value to obtain intrinsic value. Theres no way to estimate a companys future cash flows with 100% accuracy, but its financial statements are a reliable place to start. Investors will also need to research the companys growth prospects. The DCF method looks at the companys weighted average cost of capital (WACC) to discount future cash flows. WACC is the expected rate of return, which accounts for the time value of money. Using WACC, you can complete step two to bring future cash flows into the present. With those figures in hand, you can use the DCF model to estimate future revenue streams and rates of return. These give you an insight into whether the investment is worth pursuing. Financial Metric Analysis  A second way to work out intrinsic value is by applying a financial metric, like the price-to-earnings ratio. In this case, where r = expected earnings growth rate:  Intrinsic Value = Earnings Per Share (EPS) x (1 + r) x P/E Ratio. Asset-based valuation  A third option is to use an asset-based valuation to calculate a stocks intrinsic value. The intrinsic value formula for this method is perhaps the simplest of the three:  Intrinsic Value = Company Assets  Company Liabilities  Company assets would include both tangible and intangible assets, while liabilities would consist of any debts owed or similar. The downside to this type of intrinsic value is that it doesnt take growth prospects into account, which usually leads to a lower valuation. Intrinsic value of stock options  As weve mentioned above, intrinsic value calculations can be applied not only to stocks, but also to call and put options. Its used to calculate how much profit exists, or how in-the-money the option is. Options contracts give investors the right to buy or sell securities at pre-set prices, or the strike price. Its therefore helpful to understand how the intrinsic value measures up to this strike price. The intrinsic value formula in this case is:  Intrinsic Value = (Stock Price  Option Strike Price) x (Number of Options)  When the strike price is higher than the price of current shares, these options would not have any intrinsic value. There is also no applicable intrinsic value when the strike price and market price are equal. However, in the case of stock options, there might be some extrinsic value even when theres no intrinsic value. Extrinsic value looks at the external factors that impact the option pricing, such as time value. As a result, both intrinsic and extrinsic values should be considered. Understanding intrinsic values pros and cons  As you can see from the variety in calculation methods, intrinsic value can hold many meanings. It can be used as part of a fundamental or technical analysis, taking quantitative, qualitative, and perceptual factors all into account. Advantages:  Intrinsic value can uncover undervalued or discounted investment opportunities. It shows the amount of profit in options contracts. Disadvantages:  Intrinsic value of options doesnt show the full picture, as its missing extrinsic value factors like time value. There is no 100% accurate method to calculate intrinsic value, since it relies on estimations of future cash flows and risk. We can help  GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.