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What Is Intrinsic Value? Who Uses It?
A value investor is always looking for that diamond in the rough company that, for whatever reason, is currently trading below its true worth, or intrinsic value.
Their goal is to establish a position and build upon it over time. The theory is that when the tide turns and the company’s merits are finally recognized, be it through earnings reports or other valuations, its asset price will rise, and the smart investor will be rewarded.
But how can you tell what a company is worth? All too often, market prices are prone to speculation and emotion. Knowing a stock’s actual value helps investors determine whether or not it’s worth their money, and if they can get in at a discount. This is where intrinsic valuations come in.
3 Ways to Calculate Intrinsic Value
Intrinsic valuation prices a business based on the present value of all its anticipated future cash flows. Calculating a company’s intrinsic value is not an exact science. It is an estimation or projection of the future value of its stock price based on historical performance.
Investors use fundamental analysis to estimate intrinsic value, taking into consideration factors such as financial performance, business trends, current economic conditions, and the quality of its CEO and Board of Directors, to name just a few.
There are several ways to calculate intrinsic value:
- Discounted cash flow (DCF) valuation estimates a company’s future cash flows, most likely using previous cash flow statements. In this instance, one would calculate the present value of a company’s future cash flows to find its intrinsic value.
- One could also use fundamental analysis, by examining a variety of metrics, including the price-to-earnings ratio.
- Or one could use book value, which accounts for a business’ fixed and current assets, and then provide estimates into the future. The only drawback here is that this does not take into consideration the company’s liabilities.
What Is Considered to Be a “Good” Intrinsic Value?
Naturally, investors are looking for companies that sport a higher intrinsic value than current market prices. This would mean the company is currently undervalued and is trading at a discount (i.e., its market capitalization is lower than its true worth.
Can Intrinsic Value Be Negative?
Think about this in real-life terms. The smallest value a company can have is zero. Negative intrinsic values are simply not possible.
Note: In options investing, a negative intrinsic value would mean that an option is at the money or out of the money.
How Is Intrinsic Value Used?
An intrinsic valuation estimates how a business will evolve, including its growth rate, margins, and investment levels.
Intrinsic value is also used when valuing equities, such as stocks. The asset-based valuation method determines a company's intrinsic value by adding all the company's tangible and intangible assets together and then subtracting the company's liabilities from its assets. Thus, intrinsic value foretells the true value of an asset.
Are Intrinsic Value and Fundamental Value the Same?
Yes. Intrinsic value, often called fundamental value, can refer to the value of an option, product, property, or currency. It is determined through fundamental analysis. Market value, on the other hand, tells you the price other people are currently willing to pay for something. Intrinsic value shows you its value based on an analysis of its actual financial performance.
Why Is Intrinsic Value Important?
Intrinsic value is an important metric for investors to use so they can recognize when stocks are undervalued, or trading below their true worth. This usually signifies a good investment opportunity. After all, isn’t the point of investing is to grow one’s wealth? Understanding the concept of intrinsic value and the different methods you can use to calculate it can help you make well-informed investment decisions.
Estimating intrinsic value can be especially important when dealing with IPOs or young, high-growth companies, especially those companies known as “industry disruptors,” which have the potential for greatness but are currently unrecognized by Wall Street analysts.
How Does Warren Buffett Evaluate Stocks?
The world’s most famous value investor is Warren Buffett. He believes that investors should pay less for an asset than its intrinsic worth. Buffett recommends the discounted cash flow (DCF) valuation approach to approximately estimate whether a stock is attractively valued or not at its current price. Afterward, investors can use this information and their understanding of a business and industry to determine whether to invest in a particular business and for what price.
What Does Intrinsic Value Mean in Options Trading?
In options investing, intrinsic value is the difference between the option’s current price and its strike price, or the price it can be sold (for puts) or bought (for calls).
The formula for intrinsic value here is simply the price of the asset minus its strike price.
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Intrinsic Value Options Example
One of the easiest ways to illustrate the concept of intrinsic value is through options. Say a call option’s strike price is $15 and the market price is $50; the call option’s intrinsic value would be $35 because if it were exercised, its owner could buy the underlying stock for $35 less than its current market price.
Other Areas of Intrinsic Value: Digital Assets and Commodities
Over the decades, some investors have grown mistrustful of paper currencies and are finding new assets to buy and hold—particularly digital currencies such as NFTs and Bitcoin. Do these assets have intrinsic value? And what about more tried-and-true commodities, such as gold?
Do Commodities Like Gold Have Intrinsic Value?
Earlier we stated that intrinsic value is often measured by expected cash flows, and so if gold is a non-cash-flow generating asset, then in theory it has no intrinsic value. Warren Buffett in particular advises against investment in gold because its value cannot be estimated.
But for millennia, gold has been prized due to its durability as well as its scarcity, functioning as everything from jewelry to money—as an alternative to paper currency. In fact, the U.S. dollar was at one time “pegged” to gold bullion, which meant its value relative to paper money was predetermined, but in 1971 President Richard Nixon formally unpegged the dollar from the gold standard, which meant it was no longer convertible.
However, one could use a relative valuation to estimate gold’s value, such as comparing it to the price people are paying for silver, for instance. Gold witnesses an influx of investment during periods of economic crisis, as more people lose faith in paper currency or entire financial systems, as they become devalued.
Do Cryptocurrencies Have an Intrinsic Value?
In a similar vein, what value do cryptocurrencies like bitcoin have if they are not backed by anything? Cryptocurrency is one step removed from fiat currency, which is considered legal tender and tied to a national currency, like the U.S. dollar.
Cryptocurrencies are not distributed by central banks—that’s part of their appeal. But it could also be the very reason why they lack real worth. However, some argue that the intrinsic value of bitcoin could be evidenced by the cost of producing one bitcoin, which would be minimal at most.
Do NFTs Have Intrinsic Value?
Even further along the spectrum, non-fungible tokens, or NFTs, are units of data that live in digital format. They are said to have little value beyond the cost someone is willing to pay for them, precisely because they are not fungible, or interchangeable. Think of how convertible the dollar is in relation, and what types of products and services you can receive in exchange for it.
NFTs were created in 2014 as a way to trade digital art, but as of yet, there seems to be little value for them outside of the world of art and collectibles. Perhaps an age-old saying here is most appropriate: “The only value it has is the pleasure of owning it.”
