What is Intrinsic Value?
The estimated value of tangible as well as intangible resources is known as the intrinsic value of a business or a company. These resources are determined with the help of basic research or analysis. This value is also known as the true value of an organization. Normally, the company estimates this value without taking reference of actual market value. It is not necessary that the market and the Intrinsic value of a company will always be equal.
How Does Intrinsic Value Work?
The traders figure out the qualitative (target market, admin authority, business model) and quantitative (financial, other percentages and statement analysis) prospects of the business and then estimate the intrinsic value of the company. They use the comparison of estimated intrinsic value and the present market value to examine the company is depreciated or overvalued. For the calculation of the intrinsic value of a company, the most common technique is the Discounted Cash Flow (DFC) model. Discounted Cash Flow is a process to estimate the investment opportunities in the future at the present time. It uses free cash flow of the organization and the weighted mean cost of equity. The purpose is to discount the overall expected cash flows of the future to the current value. The investors use this method to find out the hidden investment possibilities. It requires a deep understanding of the basic analysis.
Intrinsic Value of Options
The intrinsic value of call options is calculated by taking the difference between the present stock price and the strike price of the option and then multiply it with total no. of shares that options can buy. Put options of the intrinsic value, the case is just inverse. This is the difference of options strike and present stock price and then multiply it with the total shared that options can buy. If in any case, the calculated value is negative, then give intrinsic value a zero value, i.e. the options will not include in money. Extrinsic value includes all the external factors that can affect the price of the option (e.g. time value and implied volatility). The total value of the price of the option can be determined by combining both intrinsic and extrinsic values.
Intrinsic Value of Options Examples
Lets suppose, If a stock has 40 USD for trading one share and you have 4 call options which allow you to purchase 100 shares at the price of 35 USD, the intrinsic value of the call options will be difference between the price of the stock and strike, that becomes $5, multiply this value with four hundred shares, you will get 2000 USD. Now, suppose, a trader buys a put option that is priced at 15 USD for fifty cents when the stock traded at 16 USD. Subtract the strike and the stock price, i.e. 15 USD – 16 USD, is -ve; so, the intrinsic value becomes 0 USD. This is because the option has no more money. However, still the option is having a value that it gets from the extrinsic value, subtract the purchase and the intrinsic values, or 50 USD – 0 USD, you will get 50 cents/share.