Intrinsic Value

Intrinsic value is the fundamental, or “true,” worth of an asset based on its underlying characteristics and expected cash flows, rather than its current market price. The term is used differently in equity valuation and in options pricing.

Key takeaways

• Intrinsic value for stocks estimates the present value of future cash flows.
• Intrinsic value for options measures how far an option is in‑the‑money.
• Calculations often rely on assumptions (growth, discount rate, risk), so results are estimates, not certainties.

What it means

• For equities: intrinsic value is an estimate of what a company is really worth based on fundamentals (cash flows, business model, competitive position, governance).
• For options: intrinsic value is the immediate profit available from exercising the option (difference between the underlying price and the strike, if that difference is favorable).

How intrinsic value is estimated (stocks)

Analysts combine qualitative, quantitative, and perceptual factors:
– Qualitative: business model, management quality, market position.
– Quantitative: revenues, margins, cash flow, financial ratios.
– Perceptual: market sentiment and technical signals.

A common quantitative method is discounted cash flow (DCF) analysis, which projects future cash flows and discounts them to present value using a discount rate that reflects required returns or cost of capital.

DCF formula

Present value = sum over t of CFt / (1 + r)^t
Where:
* CFt = expected cash flow in period t
r = discount rate (e.g., risk‑free rate, WACC)
Terminal value = estimated value after the projection period, often discounted back and added to the sum of projected years

Example (simplified)

Assume current annual cash flow is $200 and expected growth is 7% for 10 years. Using a discount rate of 3.3%:

1. Project cash flows for 10 years (Year 1 = 200 × 1.07 = 214, etc.).
2. Discount each projected cash flow to present value: CFt / (1.033)^t.
3. Sum discounted cash flows for 10 years (≈ $2,439.51 in this example).
4. Estimate terminal value (e.g., Year 10 cash flow × 15 multiple = $5,901.45), discount it back (≈ $4,265.36).
5. Total intrinsic value ≈ $2,439.51 + $4,265.36 = $6,704.87.

If the market price per share is $3,000 in this simplified example, the calculated intrinsic value suggests the stock might be undervalued.

Market risk and discounting

Risk affects the discount rate. Beta (volatility relative to the market) is often used to adjust expected return requirements:
* Beta = 1: volatility similar to market.
* Beta > 1: higher volatility → higher required return.
* Beta < 1: lower volatility → lower required return.

Higher risk generally lowers present value of future cash flows and reduces intrinsic value.

Intrinsic value for options

• Call option intrinsic value = max(0, underlying price − strike price)
• Put option intrinsic value = max(0, strike price − underlying price)
  If the difference is negative, intrinsic value is zero (the option is out‑of‑the‑money). Intrinsic value measures only the immediate exercise value; option premiums also include extrinsic (time) value, which accounts for remaining time to expiration, volatility, and other factors.

Examples:
* Call: underlying $25, strike $15 → intrinsic value $10. If premium paid was $2, net profit at expiration (if intrinsic remains $10) would be $8.
* Put: strike $20, underlying $16 → intrinsic value $4. If premium paid was $5, net result at expiration would be a $1 loss even though the put is in‑the‑money.

Pros and cons

Pros:
* Provides a framework to judge whether an asset is overvalued or undervalued.
* Essential for value investing and long-term decision making.

Cons:
* Relies on forecasts and assumptions (growth rates, discount rates, terminal multiples), making it inherently subjective.
* For options, intrinsic value ignores premium and time value, so it doesn’t represent total profit potential.

Explain like I’m five

Market prices bounce up and down as people buy and sell. Intrinsic value is an estimate of how much something is really worth underneath those ups and downs. If the real worth is more than the market price, it might be a good buy.

Market value vs intrinsic value

• Market value: current price set by supply and demand.
• Intrinsic value: estimated true worth based on fundamentals. Investors compare the two to find potential bargains.

Why it matters

Intrinsic value helps investors make informed choices by focusing on underlying cash generation rather than short‑term market movements. Value investors, in particular, use intrinsic value to identify investments that may be mispriced by the market.

Bottom line

Intrinsic value is a fundamental concept in investing and options pricing. For stocks, it is an analytically derived estimate of future cash flows discounted to present value. For options, it is the immediate exercise value. Because intrinsic value depends on assumptions, it should be used as one tool among many, not as an absolute certainty.