The inherent worth of a firm, organization, or investment project is an important indicator in today’s global financial landscape. Determining intrinsic worth is a typical commercial activity, just as negotiating purchase and sale agreements.

It is no longer conceivable to consider or engage in a large corporate deal without first establishing the transaction’s intrinsic worth. Market players purchase and sell stocks, currencies, and commodities on the stock exchange based on their estimated value. An accurate calculation of intrinsic value enables an investor to determine how much they should pay for an asset, or whether they are paying less than the market value.

**Intrinsic Value Definition:**

Intrinsic value is the true value of the assets that support the value of a firm or asset, as estimated using their financial performance.

The definition of intrinsic value differs according to the field in which it is utilized. A company’s intrinsic value represents the worth of its underlying assets, which is usually not the same as its market value.

An exchange-traded asset’s intrinsic value is the difference between the market price at which it can be sold and the asset’s true value. This term is especially significant to options trading, as an option’s intrinsic value can be either positive or negative.

The intrinsic worth of a product is its net value, which fluctuates as the economic cycle proceeds, peaking when the product is realized.

**Why is intrinsic value important?**

Worth investors assess the return on investment in a company based on its intrinsic worth. In essence, intrinsic value shows an investor how well a stock or company’s worth matches its present value.

This value is derived using a number of critical metrics to help the investor make informed selections.

- Intrinsic value is an assessment of the company’s future cash flows.

- Intrinsic value accounts for the discounting process;

- By comparing intrinsic value to current pricing, investors can determine if a stock or company is cheap or overvalued.

**How Do I Calculate Intrinsic Value?**

There are four primary ways for assessing an asset’s intrinsic value, which integrate all of the major characteristics of revenue generation by the asset:

- Discounted Cash Flow (DCF) Analysis

- Asset-based valuation.

- Analysis using a financial metric

- Dividend Discount Model(DDM)

We will thoroughly study these strategies and compare their results. To accomplish this, we’ll need an asset on which to base our computations. Shares in companies developing artificial intelligence have recently become more valuable. As a result, Apple Inc. would be an excellent candidate for this reason.

To carry out the computations, we will need the fundamental data from the company’s financial accounts.

- Market Capitalization: $2.639 trillion.

- Free cash flow is $99.58 billion.

- Free cash flow per share is $7.37.

- Cash flow growth rate in the last five years: +9.2%.

- Current share price: $213.

- Valuation period: five years

- P/FCF ratio is $26.5.

**Discounted cash flow analysis.**

This discounted cash flow analysis is the most time-consuming and accurate method. The basic premise is to deduct future cash flows using the discount rate.

The entire computation process can be broken down into three steps. We first calculate future cash flows, then estimate the cost of capital in the final period, and then discount the result to get the final intrinsic value.

- Future cash flows are calculated as free cash flow per one share multiplied by the growth rate, which in our instance is 99.58*(1+9.2%) = 99.58*1.092 = 108.74 for the second period. For the third period, the formula will be 108.74*1.092 = 118.74, and so on. We will obtain values of 99.58, 108.74, 118.74, 129.67, and 141.59.

- At the end of period 5, the stock’s estimated value equals period 5 cash flow (per share) multiplied by P/FCF. The estimated value per share is $10.46 multiplied by 26.5, which equals $277.19.

- Finally, we must discount future cash flows by the value of the discount rate. The discount rate is typically defined as the 10-year US Treasury bond yield, which represents a risk-free rate of return. In this situation, it will amount to 4% every year.

- Thus, the discounted cash flow will be equal to the sum of cash flows for all periods divided by 1 plus the discount rate. In our example, 99.58/1.05 + 108.74/1.10 + 118.74/1.15 + 129.67/1.21 + 141.59/1.27 = 94.83 + 98.85 + 103.25 + 107.16 + 111.48 = 515.57.

- As a result, the stock’s discounted intrinsic value after 5 years is (total cash flow + terminal value) divided by the number of shares. In our situation, (515.57 + 115.68)/15.288 equals 41.29. This suggests that the stock price’s intrinsic value might be around $41 in five years, $172 less than its current value.

**Dividend Discount Model**

The dividend discount method is another way to calculate share intrinsic value. This method is based on the notion of discounting free cash flows, but rather than using the free cash flow value, it uses the value of the company’s dividends.

There are various ways for discounting dividends, but the Gordon Growth Model, or GGM, is the most prevalent. This strategy is the simplest because future predicted payouts increase at the same pace. The intrinsic value formula for dividend discounting using GGM is shown below:

where:

P denotes intrinsic value.

g represents the predicted dividend growth rate.

R is the desired rate of return.

D1 represents the estimated dividend.

Using this model to calculate the intrinsic value of Apple’s shares yields the following results:

Р = 1.05/(0.08 – 0.04) = 26

The stock’s intrinsic value, including both present and future dividends, is $26. In the market, the stock price is $213. If we dismiss all information about the company, we might conclude that it is either enormously overvalued or pays very low dividends. In this circumstance, the latter is most likely to be true. Notably, this strategy is heavily reliant on the size of dividend payments, which may be a big disadvantage in practice.

Asset-based valuation

When calculating the intrinsic worth of a firm or organization, investors employ an asset-based valuation method. This is the simplest technique, with the following formula:

Intrinsic value = the sum of assets minus the sum of liabilities.

A company’s assets should contain both tangible and intangible assets, which can be difficult to determine because investment flows are rarely visible. Liabilities are a company’s debts.

If we compute the intrinsic value of Apple shares using this method, we get the following results:

$352.5 billion minus $62.37 billion equals $290.13 billion.

The estimated value is divided by the number of outstanding shares. We receive the following: $290.13 / 15.28 equals $18.98 per share.

This valuation approach has one fundamental flaw: it ignores future prospects.

Analysis using a financial metric

Financial metrics are another method for determining the intrinsic worth of a company’s stock. The simplest indicator is the P/E ratio, which compares a company’s price to its earnings. The formula for such a calculation is given below:

P/E = EPS x (1 + r) * P/E

Apple’s P/E ratio will be equivalent to:

P/E = 6.16 * (1+ 0.092) * 27.8 = 187

Based on the aforementioned earnings data and company value, Apple stock has an intrinsic value of $187. The result is the most accurate approximation to the current stock price of $213. However, this strategy does not account for future cash flows and may not be appropriate for organizations with a less steady profits growth curve.

**Risk Adjusting the Intrinsic Value.**

When determining intrinsic value, it is vital to consider hazards. The volatility of future cash flows is a common risk assessment measure that is influenced by a variety of perceptual elements that should be evaluated independently. As a result, when compensating for risk, two primary strategies are used:

- Risk-adjusting the discount rate. This strategy can result in a substantially greater time value than without risk adjustment. This is because higher risk always means higher potential returns. With this strategy, the risk is simply added to the discount rate, while the remainder of the calculation formula stays same.

- Use a probability factor to adjust for future cash flows. This strategy varies from the preceding one in that it does not modify the discount rate, but instead alters the value of the predicted cash flow using a unique reduction coefficient. The coefficient is derived as the ratio between the period’s net proceeds and the predicted net proceeds. In practice, the value of the coefficient ranges from 0.99

**Intrinsic value of option contracts**

The intrinsic value of an options contract is an important aspect in evaluating the profitability of the option.

The premise of an option contract, which lets market players to purchase or sell the underlying securities at a fixed price known as the strike price, is that it incorporates a model of two prices or values. The initial value is transient and will exist until the option expires. The second value is equally temporary; it becomes active when the price reaches the option’s strike price. In truth, intrinsic value is a measure of an option’s profitability; if it is positive, the option is lucrative; if it is negative, the option is unprofitable.

- The intrinsic value of an option varies depending on the type of option, but in general, it is the difference between the option’s strike price and its market price.

- If we’re dealing with a European or US option, we may apply the following formula to calculate the intrinsic value of stock options:

- CALL Value = (Current Market Price – Strike Price) * Number of Contracts

- PUT Value = Strike Price – Current Market Price * Number of Contracts

- However, this formula only applies to an option at the moment of expiration. If it is necessary to compute the intrinsic value of an option before expiration, the time value of the option must be added to the calculation, as it will still be present.

**An example of an option’s intrinsic value.**

Let’s see how a stock options contract works. For our example, let’s take the well-known Apple stock.

Suppose we believe that a company’s stock will rise in the future and decide to purchase a growth option. To accomplish this, we require a CALL option. The strike price is a crucial characteristic for the option. This is the point at which our option becomes profitable. Intrinsic value is also utilized in options pricing to assess how much money an option is worth.

For example, the current value of one Apple share is $200. We wish to purchase one lot of the CALL option and set the strike price to $214. Unlike futures, options have an initial price that we pay when we purchase them.

As a result, we bought a call option with a strike price of $214 for $10. The resulting income curve will look like the one shown in the graphic above. Until the market price reaches the strike price, our options contract will incur a $10 loss. When the market price exceeds the strike price by $10, the option reaches its break-even point and has intrinsic value. Next, each dollar of price movement generates one dollar of revenue. When the option reaches a price of $300, its intrinsic value is $76 (300 minus $224).

The intrinsic value of a PUT option is determined in the same way, but it profits from a price drop.

In essence, it is similar to a typical Forex exchange. However, there are two significant variances.

The loss is always restricted to the option’s initial value, therefore even if the stock price drops to $100, you can only lose $10.

Profit depends on volume. If you buy ten items for $100, you will make a net profit of 76*10 = $760. As you can see, it is far more than the income potential of a typical futures contract.

**What are the advantages and disadvantages of intrinsic value?**

While the intrinsic value measure is widely used in finance, it has serious drawbacks. The primary disadvantage of intrinsic value approaches is their reliance on input data, which fails to account for the speculative components of financial research.

For example, five years ago, such valuations were far more exact and rational. However, in today’s market, where corporations have large free-floating shares, any fundamental movement might cause price swings that cannot be predicted by objective calculations alone.

**What Are the Other Types of Valuation?**

In addition to classic intrinsic value calculation methods, there are various ways that are more specific to an investor’s risk tolerance and input data. If the investor is well-versed in examining price charts, a technical analysis method is preferable; however, if the investor is familiar with the market and similar projects, the cost approach or relative valuation method may be used.

**Technical Analysis**

Nowadays, the technical analysis method is commonly used to determine intrinsic value. The primary goal is to examine the chart of the company’s price over the selected period. This method can employ chart pattern formations or long-term forecasting methodologies such as Elliott Wave Theory. The key difference between this method and traditional valuation techniques is that it includes an element of guesswork while omitting financial metrics.

**Relative valuation.**

The comparison approach is the most often used term for the relative valuation technique. It involves comparing the value of a certain asset to that of other investments. In essence, it is similar to purchasing a commodity on the market. If other investors have purchased the item at the price you are interested in, it may be undervalued, and you might consider purchasing it. In contrast, if there is no demand from other investors at the price you are interested in, it may be regarded as overvalued, and you should either wait for the price to fall or avoid from purchasing the item.

**Cost Approach**

The cost technique is most similar to the classic intrinsic value assessment, and it is based on the project’s potential costs. If it is a company, the expected amount of investment in its development is provided. If it is a project, all costs, from hired worker pay to subsequent audits, are measured. Finally, the resulting costs are compared to those of similar projects, accounting for time considerations such as depreciation, inflation, and so on.

**Conclusion**

The computation of intrinsic value is regarded as an essential component of corporate operations, and no modern transaction in the M&A market could exist without it. Traditional valuation methods, on the other hand, are becoming increasingly obsolete with each passing year, and it is now far more frequent to see intrinsic value estimates based on technical analysis of the share price chart and fundamental analysis rather than the discounted cash flow method. As a result, whereas stock exchange experts frequently used the idea of intrinsic value a decade ago, it is now far more usual to find simpler ways of comparison that are sometimes more accurate.

**FAQ’s**

**What is the definition of intrinsic value?**

Intrinsic value is a measure of a stock’s worth that is independent of its present market price and ignores temporary market considerations. In essence, intrinsic value indicates the underlying value of a project, which may not always match the price a sensible investor is ready to pay.

**What is an option’s intrinsic value?**

The intrinsic value of an option is the difference between the current market price and the option’s strike price. The intrinsic value of a call option is the value over the strike price, whereas that of a put option is the value below the strike price.

**What are some examples of intrinsic values?**

The acquisition price paid by one corporation for another is an example of intrinsic value. If a firm is worth $100 million, it is sometimes sold for twice or even three times less since its intrinsic value is lower than its nominal value.

**When does an asset’s inherent value exceed its market price?**

When a stock’s intrinsic worth exceeds its market value, it is considered undervalued by the market and represents a good buying opportunity. If the inherent worth is less than the market price, the asset is overrated, and you should avoid buying it.