Intrinsic Value of Stocks Vs Market Price of Stocks.  Essentials of Investments Ch. 13.  CPA exam
Channel: Farhat Lectures. The # 1 CPA & Accounting Courses
Date: 2020-10-19

Intrinsic value of stocks refers to some fundamental, objective value contained in an object, asset, or financial contract. If the market price is below that value it may be a good buy, and if above a good sale. When evaluating stocks, there are several methods for arriving at a fair assessment of a share's intrinsic value

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What Is Intrinsic Value?
Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an objective calculation or complex financial model, rather than using the currently trading market price of that asset.


In financial analysis this term is used in conjunction with the work of identifying, as nearly as possible, the underlying value of a company and its cash flow. In options pricing it refers to the difference between the strike price of the option and the current price of the underlying asset.

Intrinsic Value Explained
Intrinsic value is an umbrella term with useful meanings in several areas. Most often the term implies the work of a financial analyst who attempts to estimate an asset's intrinsic value through the use of fundamental and technical analysis.

There is no universal standard for calculating the intrinsic value of a company, but financial analysts build valuation models based on aspects of a business that include qualitative, quantitative and perceptual factors.

Qualitative factors—such as business model, governance, and target markets—are those items specific to the what the business does. Quantitative factors found in fundamental analysis include financial ratios and financial statement analysis. These factors refer to the measures of how well the business performs. Perceptual factors seek to capture investors perceptions of the relative worth of an asset. These factors are largely accounted for by means of technical analysis.


Creating an effective mathematical model for weighing these factors is the bread and butter work of a financial analyst. The analyst must use a variety of assumptions and attempt to reduce subjective measures as much as possible. In the end, however, any such estimation is at least partly subjective. The analyst compares the value derived by this model to the asset's current market price to determine whether the asset is overvalued or undervalued.


Some analysts and investors might place a higher weighting on a corporation's management team while others might view earnings and revenue as the gold standard. For example, a company might have steady profits, but the management has violated the law or government regulations, the stock price would likely decline. By performing an analysis of the company's financials, however, the findings might show that the company is undervalued.

Typically, investors try to use both qualitative and quantitative to measure the intrinsic value of a company, but investors should keep in mind that the result is still only an estimate.

KEY TAKEAWAYS
In financial analysis, intrinsic value is the calculation of an asset's worth based on a financial model.
Analysts often use fundamental and technical analysis to account for qualitative, quantitative and perceptual factors in their models.
In options trading, intrinsic value is the difference between the current price of an asset and the strike price of the option.
Discounted Cash Flow and Intrinsic Value
The discounted cash flow (DCF) model is a commonly used valuation method to determine a company's intrinsic value. The DCF model uses a company's free cash flow and the weighted average cost of capital (WACC). WACC accounts for the time value of money and then discounts all its future cash flow back to the present day.

The weighted-average cost of capital is the expected rate of return that investors want to earn that's above the company's cost of capital. A company raises capital funding by issuing debt such as bonds and equity or stock shares. The DCF model also estimates the future revenue streams that might be received from a project or investment in a company. Ideally, the rate of return and intrinsic value should be above the company's cost of capital.