What is Intrinsic Value?
Intrinsic value has two primary connotations in the finance world. In the options-trading world, the term refers to the difference between the option's strike price and the market value of the underlying security.
However, the most well-known usage occurs in security analysis, where intrinsic value is the perceived value of a security (which may differ from its market value).
How Does Intrinsic Value Work?
Let's assume Company XYZ stock currently sells for $20 per share. Company XYZ just introduced a new product line, redesigned its packaging, and hired some new managers away from a competitor. Although these changes do not directly appear on the company's financial statements, they may improve Company XYZ's competitive advantage in key markets. For these reasons, investors may calculate the intrinsic value of the stock at $50 per share, or $30 more than what it is currently selling for.
There is no one intrinsic value for a stock at any given time; they vary by investor. An investor's required margin of safety, which is a measure of risk equal to the amount by which a stock's price is below its intrinsic value, determines what stock price is attractive to that investor. In the above example, if the investor's required margin of safety is 70%, the investor would only consider purchasing the stock if it traded at $15 or less.
Columbia professor Benjamin Graham, who is credited with conceiving the margin of safety concept in 1934, introduced the idea that a stock's intrinsic value could be methodically calculated. Graham demonstrated that this could be done by analyzing a company's assets and earnings and forecasting its future earnings. However, there are many ways to do this, and virtually all methods of calculating intrinsic value involve making predictions that may not be correct or are influenced by unexpected factors.
Why Does Intrinsic Value Matter?
Approaches to intrinsic value can distinguish value investors from growth investors. Although growth investors aggressively rely on earnings estimates that could be wrong, too high, or otherwise unreliable, value investors only buy stocks selling at a discount to their intrinsic value, and then patiently wait for the fair value of their investments to be realized. Even though both types of investors must face the prospect that their companies may falter, mature, or get so big that maintaining historical growth rates is impossible, most value investors buy stocks with the expectation that the stock price will rise to match the intrinsic value of the company rather than the other way around.
Intrinsic value takes the value of intangible aspects of a company into account. However, investors can never know everything about a company, and they can't always predict which factors will negatively affect a stock. Companies whose assets happen to be primarily intangible, such as technology and other companies with a lot of intellectual property, may experience considerable differences between their market values and their intrinsic values.
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