Intrinsic value refers to an investor’s perception of the inherent value of an asset, such as a company, stock, option, or real estate. With options, it refers to the in the money portion of a contract. The intrinsic value calculator is a nifty tool you can use to learn the true value of a stock.
The Intrinsic value calculator shows you if the value of a company is higher or lower than the current market value. It shows you how you can calculate the risk you’ll be exposed to if you buy. This number is extremely useful for value investors whose goal is to buy stocks and other investments at a discount to this amount.
If you didn’t already know, value investors try to find stocks that are trading for less than their intrinsic value. The general idea is to buy a stock for less than its worth, simple as that. In other words, the goal is to buy cheap stocks not cheap looking stocks.
Now, this is where things get a bit tricky as there’s no one set in stone way of evaluating a stock’s intrinsic value.
One would say that intrinsic value is subjective; two investors can form two completely different and equally valid, opinions of the intrinsic value of the same stock.
In the examples below, you will see a few different methods of the intrinsic value calculator used depending on the asset being assessed.
Different assets require different methods to calculate their intrinsic value. Take options for example. Calculating intrinsic value is easy.
You simply take the difference between the stock’s current price and the option’s strike price, then multiply by the number of shares your options entitle you to buy. Hence your intrinsic value calculator.
Intrinsic Value (options) = (Stock Price – Strike Price) * Number of Options
Say American Airlines (AAL) is trading for $35 a share. You own four call options that entitle you to buy the shares at a cost of $30.
So, the intrinsic value of your options is equal to the difference between the stock price ($35) and the strike price ($30) which is $5. Next, you multiply the difference ($5) by the number of options (4*100 shares = 400 shares).
In this case, the intrinsic value of the option is $2,000 and we refer to this as an “in the money” options. You can calculate this using the intrinsic value calculator or formula above.
On the flip side, options that are not “in the money,” have a strike price greater than the current share price. These options have no intrinsic value and are trading only for time value.
How Is the Intrinsic Value of Stocks Calculated?
- Here are there three different methods that intrinsic value is calculated:
- Price-to-Earnings (P/E) Ratio – This is the least scientific method yet thought of as the cornerstone of stock valuation. As an example, if the average S&P 500 component trades for 15 times earnings, a stock that trades for just 12 times earnings could be viewed as undervalued
- Discounted Cash Flow Analysis – In a nutshell, discounted cash flow analysis uses the time value of money with an estimation of a company’s future cash flows. And the sum of the present value of all future cash flows is the intrinsic value. Keep in mind there are several variables that need to be accounted for in this type of analysis
- Asset-Based Valuation – This is another popular method of calculating intrinsic value. You simply add up all of a company’s assets, both tangible and intangible, and then subtract its liabilities
Unfortunately, when it comes to stocks, calculating intrinsic value isn’t so straight forward. Some people feel that intrinsic value is the present value of the business’ future cash flows.
Others believe it is all the available facts that determine value. Therefore, an intrinsic value calculator may be necessary.
What’s more, there are multiple calculation methods used depending on the person doing the calculation.
Buy Cheap Stocks Not Cheap Looking Stocks
There’s a difference between buying cheap stocks and buying stocks for less than they’re truly worth. And this is the core concept of value investing; buy cheap stocks, not cheap looking stocks.
The majority of the time, when a stock is trading for below-average book value, sales or multiple of earnings, it’s for a reason. Your job is to find that reason and act accordingly on your findings.
The company could be having problems – think mismanagement or the industry may be in upheaval. It wasn’t too long ago that we had trade wars between the US and China with sanctions and tariffs imposed.
This hurts companies, especially those that rely on the smooth flow of goods with minimal cost.
Fortunately or unfortunately, depending on how you look at it, there’s no shortage of cheap-looking stocks on the market. One particular sector rife with them is the retail sector.
With the rise of e-commerce, the fall of big-box stores has come as no surprise. And with this fall comes the fall in retail stock prices; many trading at near single-digit numbers.
Take the iconic retail store Sears. After 125 years in business, they had to file for bankruptcy. Now let’s look at Macy’s; last summer it was trading at $40 and is now at $25.
This may look like a bargain but it is only truly a bargain if it has a future. How does a store like Macy’s which depends on 40% gross margins and heavy advertising survive in a world where sales are moving online?
For those gamers out there, GameStop (NYSE:GME) is another example of a stock that looks like a bargain but probably isn’t. In 2017, shares traded for just 6 times the previous year’s earnings.
Just this past year alone, price plummet from $17 to $8. I’d suffice to say GameStop’s main business of selling physical video games has a short future once the major game console makers go solely digital. This is because PC went digital long ago, and it’s only a matter of time before consoles follow suit.
In response to the changing market, GameStop is trying to adapt by selling electronics and collectibles. And rest assured, when you fast-forward ten years, the way the company makes money will be completely different from how it does now.
What does that mean to you? Well if you value the stock based on earning from a line of business that isn’t likely to be around in ten years, you might as well go buy that bottle of expensive shampoo.
The bottom line here, the intrinsic value of any stock depends on the company’s future, not just it’s present. Don’t get trapped!
All “value stocks” are not created equal. If the only reason you’re buying a stock is because of low valuation, chances are you’re making a mistake.
Unless of course, the price is so low that nearly any scenario leads to profits. Remember, most cheap stocks are cheap for a reason.
So it’s your job to find out why so you can capitalize on the true value stocks. You’re only as good as the stocks you trade.
If you need more help, take our options trading course.