On its own the word intrinsic means basic or fundamental or inborn. So instead of talking about intrinsic value, investors could equally talk about fundamental value.
Intrinsic Value of Stocks
The influential value investor, Benjamin Graham, believed the intrinsic value of a stock was a rather subtle concept and different from its market valuation as measured by the price quoted on a stock exchange.
Investors originally believed intrinsic value was arrived at by subtracting a company’s liabilities from its assets. This idea, however, ignored a company’s return on equity, profits, and future return and profit expectations. Clearly these are necessary components in determining the intrinsic value of a company.
Given that future expectations can only be estimated, the intrinsic value of a company or stock can also only be estimated. Investors should estimate a reasonable range within which a company’s true intrinsic value is likely to lie.
Most investors now measure a company’s intrinsic value by calculating the present value of all future expected net cash flows. The present value is calculated using a discounted cash flow.
For situations in which a company’s current stock market valuation is lower than its intrinsic value, Benjamin Graham coined the phrase margin of safety.
Warren Buffett explained intrinsic value to Berkshire Hathaway shareholders using an analogy with the cost of a college education.
He told his shareholders to consider the total cost of education as its book value. This cost would contain the actual cost of the years spent studying plus the earnings lost as a result of not working.
Then estimate the excess earnings resulting from the college education. That is subtract the earnings expected without the education from the earnings expected with the education.
That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day.
The dollar result equals the intrinsic economic value of the education.
Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.
Warren Buffet, Berkshire Hathaway Owner’s Manual
Intrinsic Value of Options
When dealing with an option, such as a stock option, the option’s price has two conceptual components – the intrinsic value and the time value.
Only in-the-money options have intrinsic value. The value exists because the option is priced favourably compared with the underlying asset.
For example, if ABC stock is trading at $114, while a call option on ABC stock has a strike price of $100, the intrinsic value of the call option is $14.