Intrinsic value (finance)

From Wikipedia the free encyclopedia

In finance, intrinsic value or fundamental value is the "true, inherent, and essential value"[1] of an asset independent of its market value.[2]

Options[edit]

An option is said to have intrinsic value if the option is in-the-money. When out-of-the-money, its intrinsic value is zero.

The intrinsic value for an in-the-money option is calculated as the absolute value of the difference between the current price (S) of the underlying and the strike price (K) of the option.

For example, if the strike price for a call option is USD $1 and the price of the underlying is USD 1.20, then the option has an intrinsic value of USD 0.20.

The value of an option is the sum of its intrinsic and its time value.

Equity[edit]

In valuing equity, securities analysts may use fundamental analysis—as opposed to technical analysis—to estimate the intrinsic value of a company. Here the "intrinsic" characteristic considered is the expected cash flow production of the company in question. Intrinsic value is therefore defined to be the present value of all expected future net cash flows to the company; i.e. it is calculated via discounted cash flow valuation. (This is not a proven theorem or a validated theory, but a general assumption.[citation needed])

An alternative, though related approach, is to view intrinsic value as the value of a business' ongoing operations, as opposed to its accounting based book value, or break-up value. Warren Buffett is known for his ability to calculate the intrinsic value of a business, and then buy that business when its price is at a discount to its intrinsic value.[citation needed]

Note that although stocks are assumed to be equity instruments - because they represent ownership[3] interest in the company - the 'equity' label is somewhat questionable. Class C shares, [4] for example, do not have any voting rights. The shares are considered equity instruments by finance professionals in that they are entitled to an equal share of the profits (dividends), even though shareholders lack the right to exercise control over the company.

Real estate[edit]

In valuing real estate, a similar approach may be used. The "intrinsic value" of real estate is therefore defined as the net present value of all future net cash flows which are foregone by buying a piece of real estate instead of renting it in perpetuity. These cash flows would include rent, inflation, maintenance and property taxes. This calculation can be done using the Gordon model.

See also[edit]

References[edit]

  1. ^ Ballentine, James Arthur (1916). A Law Dictionary of Words, Terms, Abbreviations and Phrases which are Peculiar to the Law and of Those which Have a Peculiar Meaning in the Law: Containing Latin Phrases and Maxims with Their Translations and a Table of the Names of the Reports and Their Abbreviations. Bancroft-Whitney. intrinsic.
  2. ^ "An Introduction to Fundamental Analysis and the US Economy". InformedTrades.com. 2008-02-14. Archived from the original on 2009-07-21. Retrieved 2009-07-27.
  3. ^ "Equity". Investopedia. Investopedia.com. Retrieved 22 March 2016.
  4. ^ Krantz, Matt. "Google execs solidify control with stock split". USA Today. USA Today. Retrieved 22 March 2016.

External links[edit]