Intrinsic value refers to how much an asset is worth, measured objectively using conventionally agreeable instruments. It is, therefore, measured using conventionally acceptable metrics, as opposed to opinions from traders or investors, who often have skewed opinions.
There is no single universally accepted formula for calculating intrinsic value because of differences in opinion as to what it constitutes. We look into some of the most common ways used to ascertain the actual value of an asset.
The intrinsic value of stocks
When it comes to stock, there is a divided opinion as to whether or not the future growth potential should be considered part of a company’s value. But the bottom line is that stocks are inherently a core component of a company’s valuation.
Discounted cash flow analysis is among the most popular ways of working out intrinsic value. The breakdown of this methodology is presented below.
Discounted cash flow analysis (DCF)
Using this approach, the valuer should evaluate three (3) key components:
- Calculate the prospective projected cash inflows/earnings for the company.
- Estimate the value of the future projected earnings from the current market price.
- Add the figure obtained in (ii) above to the value of the current stock.
The formula for calculating DCF is outlined below:
DCF: Discounted cash flow, or intrinsic value
- TV: Terminal value.
- r: The discount rate.
- CF: It’s a projected cash flow over a specified period, e.g., next one year, two years, etc.
This involves using government-issued bond yield rates to calculate the average cost of capital on a weighted scale. In addition, the evaluation has to integrate a premium, which is derived by multiplying the volatility of the stock by an equity risk premium.
The method is based on the principle that high-risk stocks have higher levels of volatility than low-risk stocks. This informs the need for issuers of high-risk stocks to give higher discounts relative to low-risk stocks. In the end, the higher discounts eat into the potential future inflows of cash into the issuing company.
Using financial position
The Price to Earnings (P/E) ratio and Earnings Per Share (EPS) are among the simplest and most common ways to evaluate the intrinsic value. The calculation is done as follows:
Intrinsic value = Earnings per share × (1 + r) × P/E ratio,
where r is the expected earnings growth rate.
Assuming that Netflix had an EPS of $5 in the previous 12-month period, and expects its earnings to grow 10% per annum for the next five years. If the P/E is at 32, its intrinsic value will be calculated as follows:
Intrinsic value = $5 × (1 + 0.1) × 32 = $176 per share
Valuation based on the asset inventory
This is quite a straightforward way of determining a stock’s intrinsic value. It used a company’s asset inventory and its liabilities to determine how much the company is worth. This method has a key weakness in that it does not incorporate the prospective growth of a company. It’s based on the assumption of an ideal situation of what happens if a company is liquidated. Its formula is as follows.
Intrinsic value = The total value of all company assets (things owned) – Total value of the liabilities (things owed)
For instance, if a company’s tangible assets are worth $300 million and intangible assets are worth $700 million, the company’s asset inventory will be worth $1 billion. Assuming the company owes $200 million, its actual worth will be:
$1 billion – $200 million = $800 million
An intrinsic value approach for options
Options trading comes in as put or call options. For options valuation, the pivot is at the strike price. With a call option, intrinsic value is the prevailing market price for the underlying asset minus the strike price. For put options, it is the price of the underlying asset subtracted from the strike price.
A negative figure means that the option is either at the money (worth the same as the current market price, but becomes negative because of the premium charge) or is out of the money (worth less than the prevailing market price and selling it leads to a loss on the stock value plus premium loss).
Valuation of options is done as follows:
Intrinsic value = (Price of the underlying asset- the strike price) × Number of options
An investor goes for an option for a stock trading at a current price of $50 and a strike price of $45. If they were to go for five call options with 100 shares, the value would be:
($50 – $45) × (100 × 4) = $2,000
If the premium charge was $3 per option, it will be
$2,000 – ($3 × 4) = $1,988
If you wondered why someone would buy an option that is out of the money, the explanation is that such options usually have time as their selling point. The time value in options trading is discussed below.
The value of time in options valuation
As intimated above, the time has a direct impact on the cost of options. This is usually more apparent for “out of the money” options. For these options, immediately selling them would be a definite loss because the options will be below the current market price of the underlying asset.
However, if the option still has some time left before the expiration date, there’s a chance that the stock will appreciate, thereby possibly leading to a profit by the options. It follows, therefore, that the longer the validity period left, the more time the options will have to return to profitability. This constitutes the time value in options.
To calculate the time value, we subtract the cost of the intrinsic value from the premium. This means that:
Time value = Cost of premium – Intrinsic value
If Snapchat is trading at $150 and we select a call option at $120 and the premium costs you $10, the intrinsic value will be $150 – $120 = $30. Considering that the premium is $10, the time value will be $30 – $10 = $20.
Some analysts have criticized intrinsic value as being out of touch with some key aspects of a business. One of the criticisms is that nobody can accurately predict the prospective income of a business. It can be challenging to estimate the actual value of startups, given that they often lack enough sales data.
We can therefore end up underestimating the potential of a great startup, especially in niche markets. Similarly, we may overestimate their value based on overambitious analysis or one-off success stories which market dynamics may have overtaken.
These calculations also fall short for some assets such as natural resources like oil and gold, whose prices are subject to many market factors, including geopolitics and speculation.
Knowing the actual value of a company is an important element in investing successfully. However, there is no universally agreed way to go about it. Investors should therefore do their valuation based on what they believe matters most in the market.