Intrinsic Value in Investments
In the world of investments, the term ‘intrinsic value’ is frequently used. It pertains to the inherent worth of an asset, calculated through an objective evaluation or complex financial model. This intrinsic value may differ from the asset’s current market price, and this discrepancy can provide valuable insight for investors, offering an indication of whether the asset is overvalued or undervalued.
Key Points to Remember
- Multiple methods exist to calculate the intrinsic or true value of an asset.
- Discounted cash flow analysis is frequently used to compute intrinsic value.
- The concept of intrinsic value is the cornerstone of value investing, helping investors discover hidden investment opportunities.
- In options trading, the intrinsic value is the difference between the current price of an asset and the option’s strike price.
- Assets with a market price lower than their intrinsic value may be wise investment choices.
Delving Deeper into Intrinsic Value
Calculating the intrinsic value of a company or stock does not follow a universal standard. Financial analysts strive to determine an asset’s intrinsic value by employing fundamental and technical analyses to assess its actual financial performance. Analysts may construct valuation models using qualitative, quantitative, and perceptual business factors. Still, the metric often used in calculations for intrinsic value is discounted cash flows.
Investors usually incorporate both qualitative and quantitative factors to gauge a company’s intrinsic value. However, it’s crucial to remember that the resulting figure is merely an estimate. Qualitative factors include aspects like the business model, governance, and target markets—elements unique to the business’s operations. Quantitative factors pertain to financial performance, including financial ratios and financial statement analysis. Perceptual factors refer to the investors’ perception of an asset’s relative worth, typically accounted for through technical analysis. Broadly speaking, the intrinsic value can be considered the worth of the business as determined by selling off the entire business and its assets.
How is Intrinsic Value Calculated?
A common method to calculate intrinsic value is through Discounted Cash Flow (DCF) analysis. This approach involves estimating cash flows based on potential business performance in the future. These projected cash flows are then discounted to their present value to derive the company’s intrinsic value. The discount rate employed is typically a risk-free rate of return, such as that of the 30-year Treasury bond. Alternatively, the company’s weighted average cost of capital (WACC) can be used.
Discounted Cash Flow Formula
The formula for DCF is as follows: DCF = CF1/(1+r)1 + CF2/(1+r)2 + . . . + TV/(1+r)n
Where:
- CF refers to the expected cash flow for a specific period.
- r is the discount rate.
- TV is the terminal value, which is the estimated cash flow post the projection period.
- n is the specific period (e.g., years, quarters, months, etc.)
The following section provides a detailed example of intrinsic value calculation using the DCF method.
Example
Let’s consider a hypothetical company – Acme Bolt Company. We’ll use its earnings available to investors as cash flow. Suppose this figure is $200 for the latest year. If the S&P 500’s hypothetical P/E multiple is 15, Acme’s per share market value is $3,000 (15 x $200). We’ll use this figure for comparison to intrinsic value. Then, using an estimated growth rate of 7%, the estimated cash flow for each of 10 years is calculated. These cash flows are then discounted using a hypothetical 30-year T-Bond rate of 3.3% (applied using the discounted cash flow formula) for each year, and the total discounted cash flow is calculated. Next, a common way to estimate the terminal value is to multiply the earnings in the final year of the projection period by a multiple of 15. That amount is then discounted. Finally, combine the first 10 years of discounted cash flows with the terminal cash flow to obtain the intrinsic value. In the given example, the intrinsic value indicates that the stock is undervalued and may be a smart investment.
Market Risk and Intrinsic Value
Many valuation models also estimate a market risk element. For stocks, this risk is measured by beta—an estimation of potential stock price fluctuation or volatility. A beta of one is considered neutral or correlated with the overall market. A beta greater than one signifies an increased risk of volatility, while a beta of less than one indicates less risk than the overall market.
Intrinsic Value of Options Contracts
The concept of intrinsic value is also employed in options pricing to determine how ‘in-the-money’ an option is, or how much profit currently exists. However, other factors like extrinsic value can affect the value of an option and its resulting premium. It takes into account external factors like the time remaining until expiration.
Why is Intrinsic Value Useful?
Understanding intrinsic value is beneficial as it helps an investor ascertain whether a potential investment is overvalued or undervalued. If the intrinsic or true value of a company’s stock is calculated to be less than its current market price, the investor may decide that the stock is too expensive at this point and not worth buying.
Market Value versus Intrinsic Value
While market value represents the current price of an asset, intrinsic value is the true value of the company, as determined using a valuation model. Some investors believe intrinsic value is a more reliable measure for investing as it is based on specific information about the asset, such as cash flows and financial performance, rather than market sentiments and trading impulses.
The Bottom Line
Knowing how to calculate intrinsic value is beneficial for investors seeking an investment’s true value. Intrinsic value is based on future cash flows, not merely where an investment may be trading currently. Since knowing intrinsic value is fundamental to analyzing securities, it’s advisable for investors to understand how to calculate it.