Intrinsic value refers to an investor's perception of the inherent value of an asset, such as a company, stock, option, or real estate. Knowing an investment's intrinsic value is useful for value investors who have a goal of buying stocks and other investments at a discount to this amount.
Calculating the intrinsic value of options
When it comes to valuing options, calculating intrinsic value is easy: Simply take the difference between the stock's current price and the option's strike price, then multiply by the number of shares your options entitle you to buy.
For example, if a certain stock trades for $35 per share and you own four call options each entitling you to buy 100 shares for $30, the intrinsic value of your options is equal to the difference between the stock price and the strike price ($5), multiplied by 400 shares, or $2,000.
Options that are not "in the money," meaning that the strike price is greater than the current share price, have no intrinsic value and are trading only for time value.
Intrinsic value of stocks or other investments
When it comes to stocks, intrinsic value can be tougher to determine since there are multiple calculation methods that can be used. Some economists believe that intrinsic value is the present value of the business' future cash flows, while others believe that it is simply the value that is justified by the available facts.
Value investors try to determine the intrinsic value of stocks by methods including (but not necessarily limited to) these:
- Discounted cash flow analysis -- Basically, discounted cash flow analysis uses the time value of money along with an estimation of a company's future cash flows. The sum of the present value of all future cash flows is the intrinsic value. There are several variables that go into this type of analysis, and you can find a complete description here.
- Analysis based on a financial metric -- Many investors use metrics such as the price-to-earnings (P/E) ratio in order to assess intrinsic value. For example, if the average S&P 500 component trades for 15 times earnings, a stock that trades for just 12 times earnings could be viewed as undervalued. This is the least scientific method, and is generally used in combination with other factors.
- Asset-based valuation -- Another popular method of determining intrinsic value consists of simply adding up all of a company's assets, both tangible and intangible, and then subtracting its liabilities.
Why it's useful
The goal of value investing is to seek out stocks that are trading for less than their intrinsic value. There is no one method of evaluating a stock's intrinsic value, and two investors can form two completely different (and equally valid) opinions on the intrinsic value of the same stock. However, the general idea is to buy a stock for less than its worth, and evaluating intrinsic value can help you do just that.
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