The Power of Intrinsic Value
Intrinsic value is a fundamental concept to find affordable investment opportunities. It refers to the true value of a business, investment or asset based on its underlying qualities and future cash flow potential, without reference to its current market price. However, investors can determine whether an asset or a business is overvalued or undervalued by comparing it to the current market price. If the market price is below the intrinsic value, this means that the investment is undervalued and may be worth purchasing. The opposite situation, where the market price is above the intrinsic value, indicates that the investment is overvalued. Investing in overvalued assets or businesses can be risky, as their market prices may eventually decline to reflect their intrinsic values potentially resulting in financial losses.
There is no industry standard for determining the intrinsic value of a company or stock. Although there are various qualitative and quantitative factors used to measure the intrinsic value, discounted cash flow (DCF) is a common method in intrinsic value estimation. This method involves projecting the future cash flows of an asset and then discounting them back to their present value using a discount rate. The formula for DCF is as follows:
Where:
- CF – cash flow for the specific period
- r – discount rate
- TV – terminal value
- n – number of periods
There are 3 reasons why to choose DCF for intrinsic value:
- Comprehensive analysis – Using an asset's fundamentals as a basis, DCF provides a comprehensive analysis by accounting for projected future cash flows.
- Time value of money – It accurately reflects the time value of money, taking into account the fact that current cash flows are more valuable than future cash flows.
- Customizable – By changing the cash flow estimates and the discount rate, the method can work with different asset classes and business sectors.
The accuracy of the DCF method heavily relies on the assumptions made regarding future cash flows, discount rates and growth rates. The process can be time-consuming and complex, requiring in-depth financial assessments and data. It is also important to note that external factors such as economic conditions, industry trends and regulatory changes can affect the validity of the projections. On the other hand, the challenge in determining intrinsic value lies in the fact that it is a highly subjective process. The final net present value is highly subject to changes in the many assumptions that must be made. Because of this, even the most successful investors in the world can use the same data to determine the intrinsic value of a company and come up with completely different estimates.
Unlike relative forms of valuations, such as comparable companies or precedent transactions, intrinsic valuation looks only at the inherent value of a business on its own. In the context of stock options (call and put options), intrinsic value is the difference between the asset’s current market price and the option’s strike price, but only when the difference is positive.
However, the intrinsic value is only positive under certain conditions:
- Call options – The intrinsic value exists when the market price of the underlying asset is greater than the strike price. If the market price is less than or equal to the strike price, the intrinsic value is zero.
- Put options – The intrinsic value is present when the market price is below the strike price. If the market price is above or equal to the strike price, the intrinsic value is zero.
To assess the value of stock options, it's essential to understand the key concepts of moneyness, which determine whether an option is profitable at its current price:
- In-the-Money (ITM) – An option with intrinsic value is considered ITM. For call options, this means the stock price is above the strike price; for put options, it means the stock price is below the strike price.
- Out-of-the-Money (OTM) – An option without intrinsic value is OTM. For call options, this means the stock price is below the strike price; for put options, it means the stock price is above the strike price.
- At-the-Money (ATM) – When the market price of the stock is equal to the strike price, the option is ATM, and its intrinsic value is zero.
For anyone trading stock options or evaluating investment opportunities, it is important to understand intrinsic value. Investors can build a comprehensive strategy to evaluate opportunities and make well-informed financial decisions by incorporating their knowledge of DCF into a larger investment analysis, as well as the intrinsic value of options.
Prepared by: Seda Janazyan, Business Analyst at CFOnline.co
