Intrinsic value (finance)
Encyclopedia
In finance
, intrinsic value refers to the value of a security
which is intrinsic to or contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value
. Simply put, it is the actual value of a security
as opposed to the market or book value
.
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, floored to zero.
For a call option
while for a put 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 total value of an option is the sum of its intrinsic value and its time value
.
, 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 flow
s to the company; it is calculated via discounted cash flow
valuation.
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.
, 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 flow
s 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
.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, intrinsic value refers to the value of a security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
which is intrinsic to or contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
. Simply put, it is the actual value of a security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
as opposed to the market or book value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
.
Options
An optionOption (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
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
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
(S) of the underlying
Underlying
In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying...
and the strike price
Strike price
In options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
(K) of the option, floored to zero.
For a call option
while for a put option
For example, if the strike price
Strike price
In options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
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 total value of an option is the sum of its intrinsic value and its time value
Option time value
In finance, the time value of an option is the premium a rational investor would pay over its current exercise value , based on its potential to increase in value before expiring. This probability is always greater than zero, thus an option is always worth more than its current exercise value...
.
Equity
In valuing equityStock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
, securities analysts may use fundamental analysis
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
— as opposed to technical analysis
Technical analysis
In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...
— to estimate the intrinsic value of a company. Here the "intrinsic" characteristic considered is the expected cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
production of the company in question. Intrinsic value is therefore defined to be the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of all expected future net cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s to the company; it is calculated via discounted cash flow
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
valuation.
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
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
, or break-up value. Warren Buffett
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
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.
Real Estate
In valuing real estateReal estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
, a similar approach may be used. The "intrinsic value" of real estate is therefore defined as the net present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of all future net cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s 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
Gordon model
The Gordon growth model is a variant of the discounted cash flow model, a method for valuing a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax planning, and business transactions that don't have an explicit market value. It is named after Myron J....
.
See also
- Net Realizable ValueNet realizable valueNet realizable value is a method of evaluating an asset's worth when held in inventory, in the field of accounting. NRV is part of the Generally Accepted Accounting Principles and International Financial Reporting Standards that apply to valuing inventory, so as to not overstate or understate the...
- Option time valueOption time valueIn finance, the time value of an option is the premium a rational investor would pay over its current exercise value , based on its potential to increase in value before expiring. This probability is always greater than zero, thus an option is always worth more than its current exercise value...
- Option (finance)Option (finance)In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
- Expected valueExpected valueIn probability theory, the expected value of a random variable is the weighted average of all possible values that this random variable can take on...