What is Intrinsic Value of Shares and how to measure it
Just as the intrinsic value of a business tells how much it would be worth if it were to liquidate and sell everything, the intrinsic value of a share tells investors how much its shares are worth. For instance, even though a business makes consistent profits, its stock price may fall if its management breaks the law. However, if we examine the company’s financials, we may find that the stock is undervalued. In this case, investors can accordingly decide how much to pay to buy these shares.
Intrinsic value of share meaning
Do you know what is the intrinsic value of a share and how to determine it? Intrinsic value is used in financial analysis to describe the process of determining the underlying value of a company and its cash flow. In options pricing, it alludes to the discrepancy between an option's strike price and the current value of the underlying asset.
Investors in the stock market take a stock’s intrinsic value under consideration when deciding whether or not to buy the said stock.
An objective assessment of the share gives it a certain financial strength, referred to as its intrinsic value. The seller will profit if a share's intrinsic value is higher than its market value. The buyer will benefit if the inherent value of the share is lower than its market value. Therefore, it is essential to comprehend the basic elements that determine an asset's intrinsic value to comprehend the fundamental economics of the stock market.
There isn't a single formula for determining a company's intrinsic value. Financial analysts develop valuation models based on qualitative, quantitative, and perceptual characteristics of a company. They develop an efficient mathematical model for weighing these variables. Once they know these variables, they compare the value produced by this model to the asset's current market price. This comparison tells them if an asset is overvalued or undervalued.
Market risk and intrinsic value
While calculating the intrinsic value, many valuation models consider the market risk component. For equities, it is beta—a numeric value that measures fluctuations of a stock’s price as compared to the changes in the overall market. If the value of beta is 1, it means the stock price moves in tandem with the market. But if the value is less than one, it means the stock is less volatile than the market. While if beta goes above one, it means the stock is more volatile than the market as a whole. Compared to an investment with a low beta, a stock with a high beta should generate a higher return to offset the higher risks.
An investor using this type of method to calculate the intrinsic value of a share might get blindsided. We all know companies are affected by factors that cannot be calculated. In fact, the calculations we do carry out are often based on estimations. For example, an investor can’t know how effective the newly selected management team would be. In such cases, investors might understate the risk or overestimate the cash flows. But these factors would distort the company's intrinsic value.
Intrinsic Value of Options Contracts
Let’s quickly review how options work. An options contract gives the buyer the option to buy or sell the underlying securities at a predetermined price (called the strike price). However, these investors don’t have to honour the contract. For example, investor A purchases stocks using a call option. And an investor B sells it using a put option. Now, the call option is lucrative if the market price on the date of expiry is higher than the strike price. The put option is profitable if the market price is lower than the strike price. However, if neither option is profitable, the buyer or the seller don’t have to honour the contract and the buyer forfeits any upfront premium that was paid.
Now, how does intrinsic value enter the picture? Basically, intrinsic value of an options contract is the amount by which strike price is profitable when compared with its stock price. In other words, intrinsic value helps us figure out how far the strike price of a stock has surpassed the current stock price (or in-the-money) and how much profit is now available. That is, the difference between the stock price and its strike price is the intrinsic value of both call and put options. If the difference is negative, the intrinsic value is zero for both call and put options.
An option may still have extrinsic value if there is sufficient time before expiration to make a profit. This is even if the strike price and market price are equal. This is known as an option with no intrinsic value.
Considering intrinsic value might help you decide how much to pay for stock shares. However, not every asset has an intrinsic value since it assesses the worth of an asset based on cash flows and not the current market value. By this logic, assets like gold or silver do not have a cash flow since they do not generate a stream of income and therefore, have no cash flow. In some cases, it also might become difficult to figure out the intrinsic value of a company, for example, when dealing with start-ups with no sales. Regardless of these limitations, intrinsic value remains a one of the fundamental approaches of analysing securities.
Q. How is the intrinsic value determined?
Dividend discount models, residual income models, and discounted cash flow models are used to calculate the intrinsic value.
Q. What is the Intrinsic Value per Share (IVPS)?
The intrinsic value of a corporation divided by the number of shares is known as the intrinsic value per share (IVPS).
Q. What role does personal finance have in intrinsic value?
When deciding whether to get a mortgage or pay off one's intrinsic value per share (IVPS) early, intrinsic value is used as a guide. It can also be used to decide whether or not investing is prudent.
Financial instruments that are held for 12 months or less are considered as short-term investments. These are instruments that can typically be converted into cash easily.