how to calculate intrinsic value
using discounted cash flow dcf analysis cash flows are estimated based on how a business may perform in the future those cash flows are then discounted to today s value to obtain the company s intrinsic value the discount rate used is often a risk free rate of return such as that of the 30 year treasury bond 1 it can also be the company s weighted average cost of capital waac discounted cash flow formuladcf cf1 1 r 1 cf2 1 r 2 tv 1 r ncf the expected cash flow for a specific period e g cf1 cash flow year one r the discount ratetv the terminal value estimated cash flow after the projection period n the specific period e g years quarters months etc as an example let s use the earnings available to investors from our acme bolt company as cash flow say this figure is 200 after adding depreciation and subtracting capital expenditures for the latest year if a hypothetical p e multiple for the s p 500 is 15 acme s per share market value is 3 000 15 x 200 we ll use that figure for the comparison to intrinsic value using an estimated growth rate of 7 the estimated cash flow for each of 10 years is next we discount these cash flows using a theoretical 30 year t bond rate of 3 3 we apply it using the discounted cash flow formula shown above for each year for example the formula for the first year is cf 1 r the discounted cash flow for each of 10 years is the total discounted cash flow is 2439 51 then a quick and common way to estimate the terminal value is to multiply the earnings in the final year of the projection period by a multiple of 15 that s 393 43 x 15 5897 10 that amount discounted is 4262 21 5897 10 1 03310 finally combine the first 10 years of discounted cash flows with the terminal cash flow for the intrinsic value 2439 51 4262 21 6703 72compared to acme s current share price of 3000 the intrinsic value of 6701 72 indicates the stock is undervalued and is worth considering as an investment intrinsic value is at the core of value investing benjamin graham who is considered to be the father of value investing was a mentor to famed investor warren buffett market risk and intrinsic valuea market risk element is also estimated in many valuation models for stocks the risk is measured by beta an estimation of how much the stock price could fluctuate or its volatility a beta of one is considered neutral or correlated with the overall market a beta greater than one means a stock has an increased risk of volatility while a beta of less than one means it has less risk than the overall market if a stock has a high beta there should be greater return from the cash flows to compensate for the increased risks as compared to an investment with a low beta intrinsic value of options contractsintrinsic value helps determine the value of an asset an investment or a company intrinsic value provides the amount of profit that exists in an options contract calculating the intrinsic value of a company can be subjective since it estimates risk and future cash flows the intrinsic value of an option is incomplete since it doesn t include the premium paid and time value intrinsic value is also used in options pricing to determine how in the money an option is or how much profit currently exists to review an options contract grants the buyer the right but not the obligation to buy or sell the underlying security at a preset price called the strike price options have expiration dates by which they must be exercised or converted to the shares of the underlying security the intrinsic value of both call and put options is the difference between the underlying stock s price and the strike price if the calculated value is negative the intrinsic value is zero in other words intrinsic value only measures the profit as determined by the difference between the option s strike price and market price so an option with a strike price that equals the market price at expiration an at the money option will have zero intrinsic value however other factors such as extrinsic value can affect the value of an option and its resulting premium it takes into account other external factors such as how much time is remaining until expiration if an option has no intrinsic value meaning the strike price and the market price are equal it might still have extrinsic value if there s enough time left before expiration to make a profit as a result the amount of time value that an option has can impact an option s premium both intrinsic value and extrinsic value combine to make up the total value of an option s price let s say a call option s strike price is 15 and the underlying stock s market price is 25 per share the intrinsic value of the call option is 10 25 minus 15 if the option premium paid at the onset of the trade were 2 the total profit would be 8 if the intrinsic value was 10 at expiry on the other hand let s say an investor purchases a put option with a strike price of 20 for a 5 premium when the underlying stock was trading at 16 per share the intrinsic value of the put option is the 20 strike price less the 16 stock price or 4 in the money an intrinsic value of 4 at expiry combined with the premium paid of 5 means the investor has a loss despite the option being in the money it s important to note that the intrinsic value does not include the premium it s not the same as the actual profit on the trade since it doesn t include the initial cost intrinsic value only shows how in the money an option is considering its strike price and the market price of the underlying asset 