Meaning of Intrinsic Value
The intrinsic value, theoretical price or fundamental value of an asset, is the value that is obtained taking into account all the components that surround an asset, including tangible and intangible elements. It is also sometimes known as real value.
It is also said that the intrinsic value is that which a rational investor, fully informed about everything that surrounds that asset is willing to pay for it. Of course, depending on the complexity of the asset, it will be easier or almost impossible to be fully informed of everything that surrounds an asset. One of the assets most valued by analysts (and most complex to value) are stocks.
Intrinsic value is used when we assume the principle of going concern, that is, that the company will continue to operate in the future. If, on the other hand, we cannot assume that the company will continue operating in the future, we must calculate the liquidation value.
In an efficient market, market prices show intrinsic value. Therefore, they are considered reliable indicators of intrinsic value in many areas. For example, in accounting, market prices are taken as the correct valuation of assets.
Analysts use different valuation models to determine the intrinsic value of an asset (a stock or bond for example) and then compare it with the market price to determine if the market price is priced appropriately. Or if, on the contrary, it is overvalued (the market price is greater than the intrinsic value) or undervalued (the market price is less than the intrinsic value). At the end of the article we see why an asset can have a wrong price and when it can be acted upon.
How to Calculate Intrinsic Value?
To calculate the intrinsic value of an asset, we must first know what type of asset we are valuing. Depending on the type of asset, there are several valuation models. We are going to see the most common valuation models for a share and a bond:
1. Intrinsic Value of a Share
It is the intrinsic value of the shares of a company. In order to know the value of a share, it is necessary to value the company. For this, there are multiple methods of valuation of companies. These are the most common:
- Flow Discount Models: They are the most used models because they calculate the value based on future profits or income. There are different models for discounting flows:
- Discounted Dividend Method: These are methods for valuing the price of a company’s share based on the dividends that the company is going to distribute in the future. The most widely used dividend model is the Gordon Model.
- Free Cash Flow Discount Models: It is one of the most used methods, since it directly calculates the money that enters and leaves a company, estimating future cash flows.
- Method of Valuation by Multiples: They use multiples of the information in the income statement to value a company. For this reason, they are also known as profit and loss-based valuation methods to calculate the value of the company. The most used ratios are PER, company value and EBITDA.
- Accounting Valuation Models: It is the accounting value that a company should have and whose information is extracted from the balance sheet of a company. The intrinsic value that results from these models is known as the theoretical book value.
The most important business valuation models can be seen grouped in the following scheme:
2. Intrinsic Value of a Bond
The intrinsic value of a bond is much easier to calculate than that of a share, mainly because by buying a share we are dreams of the company and for this it is necessary to value it. Whereas with the purchase of a bond we become lenders of the company. What we have to calculate is the value of a loan.
The present value of a bond is equal to the cash flows that will be received in the future, discounted at the current moment at an interest rate (i), that is, the value of the coupons and the nominal value to date of today. In other words, we have to calculate the net present value (NPV) of the bond:
For example, if we are on January 1 of the year 20 and we have a two-year bond that distributes a coupon of 5% per year paid semi-annually, its nominal value is 1000 euros that will be paid on December 31 of year 22 and its rate of Discount or interest rate is 5.80% per year (which is 2.90% semi-annual) the price will be:
If the interest rate is equal to the coupon, the price of the bond exactly matches the face value. In this case 1000 euros.
If the bond does not have coupons (zero coupon bond) the price of the bond is equal to the nominal value discounted today:
If the bonds have call options (callable bond) we will have to subtract the option premium from the price and if they have put options ( putable bond ) we will have to add the option premium.
Intrinsic Value Analysis
If the market price is very different from the intrinsic value, investors need to analyze why an asset is priced wrong.
When markets are efficient, the price of shares approaches their intrinsic value. However, the more inefficient a market is, the greater the likelihood that a stock will be priced far beyond its intrinsic value.
The behavioral finance also play an important role in the deviation of prices, since emotions of buyers and sellers will cause at times the market prices of adjustment of their intrinsic value, these market anomalies can occur even in efficient markets. On many occasions, faced with events that surprise the market, the overreaction effect occurs.
Analysts who are able to estimate the intrinsic value of an asset better than the market will have a competitive advantage and will be able to obtain returns better than the market average, when the market price moves towards its intrinsic value.
- The greater the difference between the intrinsic value and the market price, the greater the incentives to position itself in the asset. In stock analysis this difference is known as the margin of safety.
- The more confidence an analyst has in your valuation model and the data used, the greater their incentive to position themselves in it.
- The less efficient a market is and the fewer investors analyze the market prices of its assets, the greater the incentives to analyze it, as the probability of a mismatch between intrinsic value and market price.
- To position itself in an asset an investor must believe that the market price will tend to the intrinsic value. For asset valuation to be profitable, market prices must converge to intrinsic value. The more investors analyze an asset, the greater the probability that the market price is correctly valued.
In the case of bonds, what we have to study is the interest rate (or the bond’s pull), since the market price will adjust according to this interest. The IRR of the bonds is composed of the risk-free interest (for example, the interest paid on German bonds), plus the country risk, plus the company’s credit risk.
If we believe that the credit risk or the country risk is much lower than that investment actually supposes and we are right, what should happen is that the bond of that bond goes up and therefore the price goes down. If, on the other hand, the interest rate is too high, we can buy the bond since we expect its price to rise.