What Is Intrinsic Value? Importance And Ways To Determine
Updated 30 September 2022
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Intrinsic or fair value is a concept that measures the worth of an asset and helps investors decide whether an asset is under or overvalued in relation to the asset's current market value. It is an essential aspect of the fundamental analysis that helps investors assess the price of stocks. Understanding what it means and how to calculate it can help you make smart and intelligent investment decisions. In this article, we discuss what intrinsic value is, explore the fair value of stocks along with pros and cons, explore the methods for determining it and understand its importance.
What is intrinsic value?
Intrinsic value is a financial concept that measures the overall value of an investment based on its cash flows. To calculate this value, companies can use both fundamental and technical analysis. It helps to identify the perceived value of an asset. While market value shows the price others are likely to pay for an asset, the fair value determines its value based on its actual financial performance. Also, fair value is the rational price an investor pays for a stock or asset after considering the risk.
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Importance of intrinsic value
This is one of the most important financial concepts because it helps an investor understand the perceived value of an asset. It determines whether an asset is over or undervalued when compared to the market value. Determining the fair value helps an investor make educated investment opportunities. Determining the perceived value of an asset and using it to build a strong portfolio can help maximise return on investment.
Another reason fair value is essential for an investor is that it determines whether an asset is a good sale or buy. An asset with a current market price below the fair value is a good buy, whereas an asset is a good sale when the current market price is above the fair value.
Fair value vs. market value
Though both fair value and market value are a way of valuing a company's assets, fair value estimates the actual value of an asset, irrespective of the market value. Market value measures how much the market values a company or how much would it cost to buy a company. The market value reflects the demand and supply in the investing market and determines the willingness of investors to take part in making investments in a company.
When investing in a company, asset or stock, investors usually look for assets with a higher fair value than market value because such assets are excellent investment opportunities.
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The intrinsic value of options contract
An option contract is a financial agreement between two parties that focus on a potential transaction that involves an asset at a preset price and date. These contracts help a buyer sell or buy an asset depending on the type of contract. The preset price at which a buyer can sell or buy them is the strike price. A put option gives the investor the right to sell an asset, while a call option gives them the right to buy it.
The formula for calculating the fair value of options contract is:
Intrinsic or fair value = (Stock price – Strike price) × Number of options
Fair value calculation gives investors an accurate representation of their asset's value. If the value is negative, the fair value is zero. This implies that fair value only determines the profit. Also, this shows that out-of-money options have no fair value and trading for such options is for their time value. Also, a put option is in-the-money when the market price is below the put option's strike price at the time of expiration. A call option is out-of-money when the market price is above the strike price at the time of expiration.
Pros of the fair value of options contract
The pros and cons of finding a fair value of options contracts are:
The pros of finding the fair value of options contracts are:
Helps determine the fair value of the company, investment or asset.
Helps identify the amount of profit that exists in an options contract.
The cons of finding the fair value of options contract are:
Evaluates the future cash flows and risks based on estimation.
Incomplete calculation because it does not include time value and premium paid.
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4 ways to calculate the intrinsic or fair value
Here are four different ways of calculating the fair value of an asset or stock:
1. Discounted cash flow (DCF) analysis
Discounted cash flow analysis is the most common method for calculating the asset's fair value. It uses the time value of money and estimation of future cash flows to calculate the fair value. In a DCF analysis, investors first calculate the company's future cash flows, then calculate the present value of each of the future cash flows. The investor then adds the present value of all the assets to reach fair value. Also, the weighted average of capital (WACC) represents the time value of money.
The formula for calculating fair value using DCF is:
Intrinsic or fair value = (CF1) ÷ (1+r)^1 + (CF2) ÷ (1+r)^2 + (CF3) ÷ (1+r)^3 + …… + (CFn) ÷ (1+r)^n
CF1 is the cash flow in year one, CF2 is the cash flow in year two and so on
r is the rate of return a company can get by investing money somewhere else
2. Asset-based valuation
Using an asset-based valuation, investors can calculate a stock's fair value. In this method, the investor adds a company's tangible and intangible assets before subtracting the total liabilities from the total assets. Though it is a simple way, it is an effective way to calculate the fair value. The formula for calculating fair value using this method is:
Intrinsic or fair value = (Sum of company's tangible and intangible assets) – (Sum of company's total liabilities)
If the company's assets totalled ₹40,00,000 and the liabilities totalled ₹24,50,000. The fair value of the company is:
Fair value = 40,00,000 – 24,50,000 = ₹15,50,000
The downside of asset-based valuation is that it does not incorporate any growth aspect and as a result, it yields much lower intrinsic value than all other methods.
3. Analysis based on the financial metrics
Another way investors can calculate the fair value of an asset or stock is using financial metrics such as the price-to-earnings (P/E) ratio.
The formula for calculating the fair value of a stock is:
Intrinsic or fair value = Earning per share (EPS) × (1+r) × P/E ratio
where r = expected earnings growth rate
Calculating the fair value is the least scientific method and investors often combine the analysis method with another valuation method.
For example, if a plant manufacturing generated an earning per share of ₹50 over the last 12 months. The company grows by 14% over the next 10 years with a P/E multiple of 45.
Fair value = ₹50 × (1+0.14) × 45 = ₹2,565 per share
4. Dividend discount model
The dividend discount model is another excellent way to calculate the fair value of a stock or asset. This model considers the dividends a company pays to the shareholders. The model has many variations based on the business assumptions and variables used. One of the most widely used dividend discount models is the Gordon Growth Model.
The formula for calculating fair value using the Gordon Growth Model is:
P = D1 ÷ (r – g)
where P is the present value of the stock
D1 is the expected dividends one year from the present
r is the required rate of return for equity investors
g is the annual growth rate in dividends
Example of fair value
Using the methods mentioned above, an investor wants to understand whether the fair value of a security is lower or higher than the market price. When calculating a stock's fair value, investors keep a margin of safety for scenarios when the market price reaches below the fair value. Here is an example of understanding the concept:
A company you believe has strong cash flow opportunities. The company trades at ₹500 per share. After performing the DCF analysis, an investor finds out that the fair value is ₹800 per share, a bargain of ₹300 per share. Assuming that the margin of safety is 30%, the investor purchases the stock at ₹500 per share. If the fair value drops by ₹100 per share the following year, the investor still saves ₹200 from the initial DCF value. This gives the investor the ability to take the risk, even if a sharp drop in the price occurs.
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