What is Intrinsic Value?

Intrinsic value is like a car without accessories…

You can load up a new car with a whole lot of extras these days. Leather seats, a heated steering wheel, an impressive stereo system, and a paint job that catches the eye of everyone on the road. But, at the end of the day, the car’s purpose is to transport you from point A to point B. Although all those added features provide some added comfort and score you some cool points with your friends, the intrinsic value of the vehicle is what you would pay to get around if you didn’t own a car at all.

There are two primary aspects a financial analyst might use to determine a company’s intrinsic value: quantitative and qualitative.

The primary source a company derives its value from is the income it generates for the owners — This is a quantitative measure, as the value can easily be expressed in numbers. Assessing this value is commonly done using a technique called discounted cash flow (DCF).

The idea behind DCF analysis is that if you had $100 today, you could invest it. Say you could earn a 5% return on investment. That would mean you would have $105 next year. In other words, receiving $105 next year is the same as getting $100 now.

Future dollars are not worth as much as present dollars. This fact implies that we must discount future cash flows to account for the different time value of money. To do so, you must divide a future payment by one plus the discount rate, raised to the number of periods in the future the payment will arrive. Discounted Value = Future Payment / (1 + discount rate) ^ # periods

Let’s say that you expect a payment of $150 in three years and that you can earn a 5% interest rate on any money you have today.

Discounted Value = $150 / (1.05)^3

Discounted Value = $150 / 1.16

Discounted Value = $112.70

So, if you had $129.31 today, you would have $150 in three years. Therefore, the discounted value of that future payment is $129.31 today.

In the case of a company, you must discount each year’s expected cash flows, typically by the weighted average cost of capital (WACC), which is the return on equity you must earn to cover the cost of borrowing the money. Doing so will give you the discounted cash flow of the company. Adding all of those discounted values together provides you with the net present value (NPV) of the company’s revenue stream.

The above examples are intended for illustrative purposes only and do not reflect the performance of any investment.

If the company had the same projected cash flows for every year going forward, you could take a shortcut — Take one over the discount rate to determine the multiplier.

So, a 10% discount rate would be 1/.1 = 10, and a 5% discount rate would be 1/.05 = 20. Because all of the numerators are the same, multiplying the present earnings by the multiplier would give you the NPV. Equivalently, dividing the present earnings by the discount rate would give you the same answer.

Analysts will often add a subjective (qualitative) amount to the NPV to determine the intrinsic value. Because the intrinsic value is the true value of the company, this amount is intended to capture some intangibles that the company may possess. This increment could be anything from the strength of the company’s brand to the abilities of its management team.

Many investors that adhere to fundamental analysis don’t like this additional value since it’s subjective. Consequently, the intrinsic value of a company will often vary depending on who does the analysis.

Stocks are essentially certificates of ownership in a company. The stock’s price is what people are willing to pay for one share of the equity in that company. There are many reasons a person might want to purchase a company's stock.

One reason is that they want the periodic distribution of profits to the equity owners — Which is called a dividend. Another reason might be that they expect the company to grow. Getting in early would allow the trader to reap the benefits of that growth.

But, sometimes, an investor might just like the company and its products. They might want to be associated with that company and its mission. Or, an investor might think that the stock price will increase for some reason, without any change to the business model or its product lines.

Stock prices change every day, as buyers and sellers have different investment needs and beliefs about a company’s future. But a company’s intrinsic value is rooted in its operations. It is likely to increase when new products are successfully launched; and, it is likely to decrease when consumers turn their backs on products that lose their interest. The intrinsic value should not move based on how investors feel one day, or because another company steals the spotlight. It only changes when the core business functions change.

Three main types of value pertain to a company trading on the stock market.

Intrinsic value is a computed number based on its expected future cash flows. It is the value assigned by analysts and estimates what someone would be willing to pay for the company if it were sold today.

Book value is an accounting term. It is a measure reported on the company’s balance sheet, which accounts for the recorded value of its assets, less depreciation, minus its liabilities. It is the theoretical amount of money the company would receive if they sold all the assets and paid off all the debts.

Market value is how much the stock of the company is worth. It is found by multiplying the stock price by the number of outstanding shares.

One of the most famous proponents of intrinsic value is Warren Buffet. He spent his life trying to understand what a company is worth, then buying up shares whenever the market undervalued that company’s stock. Market risk exists whenever the price of a stock has a significant chance of falling after you buy it. The higher that a company’s stock price goes relative to its earnings (called price to earnings ratio, or P/E ratio), the more difficult it will generally be for that price to rise further. If the company underperforms expectations, the stock’s value may fall rather quickly.

And some companies just seem to see their stock prices jump all over the place. The metric traders use to capture that volatility is called beta. Beta and P/E ratios can tell you a little bit about the market risk you are taking on. And comparing these metrics to the company’s intrinsic value can help you identify companies that you think have a lower risk and more potential reward.

Intrinsic value can also be used to determine how much an option or an asset is worth. An option provides the owner with the right, but not the obligation, to purchase (in the case of a call option) or sell (in the case of a put option) an asset at a later date. The price of that purchase or sale is called the strike price and is determined ahead of time — when the contract is executed.

For example, say you had an option to purchase one million barrels of oil for $75 million at any time within the next year. You would want to watch the price of oil. If it ever goes above $75 per barrel (the strike price), you could exercise your option. Let’s say oil starts trading at $80 per barrel. You could exercise your option, purchase the oil for $75 per barrel, then immediately sell the oil at the $80 spot price, and turn a $5 million profit, minus the cost of the contract.

The intrinsic value of that call option is the amount by which the option is “in-the-money” (current price of the asset minus the strike price). If oil never crossed that $75 mark, you would simply let the option expire. Therefore, an option never has an intrinsic value below zero.

Also worth noting is that a call option can have some value even if it is not currently “in-the- money.” This situation usually happens because there is still time left on the opportunity, which means that the market price may rise above the strike price before it expires. What someone is willing to pay for that remaining option is called time value.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.