Intrinsic value

Definition

In finance and investing, intrinsic value refers to the actual or inherent worth of an asset or investment, independent of its current market price.

What is intrinsic value?

Intrinsic value is a fundamental concept used in valuation and is especially relevant when evaluating stocks and other securities. The intrinsic value is often contrasted with the market price, and the goal of many investors is to find assets whose intrinsic value is higher than their market price, suggesting they are undervalued.

Determining intrinsic value typically involves conducting a fundamental analysis. This fundamental analysis considers various factors, including the company’s financial health, earnings potential, growth prospects, and the overall economic environment.

In the context of stocks, the intrinsic value of a company’s shares is an estimate of what they are truly worth based on factors like the company’s earnings, assets, and growth potential. Investors often use methods such as discounted cash flow (DCF) analysis or price-to-earnings (P/E) ratios to estimate intrinsic value.

Value investors seek to identify stocks that are trading below their intrinsic value. They believe that over time, the market tends to correct such mispricings, and the stock’s price will rise to reflect its intrinsic value. It’s often associated with a long-term investment perspective. Investors who focus on intrinsic value are typically less concerned with short-term market fluctuations and more interested in the long-term growth and stability of their investments.

Calculating intrinsic value can be somewhat subjective because it depends on various assumptions and estimates. Different analysts may arrive at slightly different intrinsic value estimates for the same asset.

If the market price of an asset is below its intrinsic value, it may be considered a buying opportunity. Conversely, if the market price is significantly higher than the intrinsic value, it could be a signal that the asset is overvalued.

Market value vs. intrinsic value

Market value refers to the current price at which an asset can be bought or sold in the marketplace, determined by supply and demand dynamics. Intrinsic value, on the other hand, is an estimate of an asset’s true worth based on fundamental analysis, including factors such as future cash flows, earnings potential, and financial health. Market value can fluctuate due to market sentiment, while intrinsic value aims to reflect the underlying, long-term value of the asset. Investors often compare the two to identify undervalued or overvalued assets.

Example of intrinsic value

ABC Corporation is a publicly traded company with shares listed on the stock exchange, and has stable earnings and dividends. Let’s assume it has an annual dividend per share of £2.

An investor, considering buying shares of ABC Corporation, has a required rate of return of 8%.

The intrinsic value of a stick can be calculated using the formula:

Intrinsic value = Dividend per share / (Required rate of return – Dividend growth rate)

Let’s assume the dividend growth rate is 5%

Intrinsic value = 2% / (0.08 – 0.05) = £66.67

The calculated intrinsic value of £66.67 represents the estimated true worth of one share of ABC Corporation based on its dividends, the investor’s required rate of return, and the expected growth rate of dividends.