Intrinsic Value Explained: What It Is and How It Works?

The Intrinsic Value of Stocks

Intrinsic value refers to the perceived true worth of a company or its stock, based on a thorough assessment of its fundamentals—rather than its current market price. While it’s often confused with market value, the two are fundamentally different. Market value reflects what investors are willing to pay at a given moment, whereas intrinsic value aims to capture what the business is actually worth over the long term.

There is no single method to calculate intrinsic value. Analysts typically rely on a combination of tools and approaches, evaluating both quantitative factors—like earnings, cash flows, and financial ratios—and qualitative elements such as leadership, business model, and competitive edge. By estimating intrinsic value, investors can better judge whether a stock is under- or overvalued and decide how much they should be willing to pay for it.
 

Why is Calculating Intrinsic Value Useful?

Calculating the intrinsic value of the shares is quite important as it factors in both the qualitative and the quantitative aspects of the share. Calculating the intrinsic value is the first step toward conducting a fundamental stock analysis. Therefore, you need to know how to calculate the intrinsic value of a stock. 
Also, only if you calculate the share's intrinsic value will you get a benchmark to compare it with the stock's current market price. As the calculation of the intrinsic value includes different values from the financial statements, it gives you a true picture of the performance of the stocks.

How to Find the Intrinsic Value of a Stock?

There are different ways of finding the intrinsic value of the stock. You must know how to calculate a stock's intrinsic value using these methods to use the information available effectively. Let's have a look at different ways in which you can calculate the intrinsic value of a share.

● Discounted Cash Flow Analysis

The discounted cash flow analysis is the most commonly used method of calculating the intrinsic value of a share. It is also known as the DCF analysis. You need to perform three simple steps while using this method to calculate the intrinsic value:

● Calculate the future cash flow of the company whose stocks you plan to invest in.

● Now, calculate the present value of all the estimated future cash flows.

● Calculate the sum of all these present values to arrive at the share's intrinsic value.

Calculating the future cash flow of the company is quite challenging. You will have to analyze the company's financial statements to estimate future cash flows. Also, you will have to go through news articles and editorial pieces to understand the company's growth.

The formula used in this method of calculating the intrinsic value of the share is:

Intrinsic value = (CF1)/(1 + r)1 + (CF2)/(1 + r)2 + (CF3)/(1 + r)3 + ... + (CFn)/(1 + r)n

Here,    
CF shows the cash flow, where CF1 is the cash flow of the 1st year, and so on.
'r' is the rate of return based on the existing market standards.

●  Analysis Based on a Financial Metric

Another popular way of calculating the intrinsic value of a share is conducting an analysis based on a financial metric. Popular ratios like the price-to-earnings ratio, etc., can be used to calculate the share's intrinsic value.

However, to use this metric, you must have the information available to help you calculate the P/E ratio. The formula to calculate the intrinsic value of the share using this method is:
Intrinsic value = Earnings per share (EPS) x (1 + r) x P/E ratio
Here, r stands for the expected growth rate of the earnings.

●  Asset-Based Valuation

You can also use the asset-based valuation method to calculate the share's intrinsic value. New investors use this method as it does not involve complex calculations of the future and the present values of the company's cash flow. The formula used in this method is:

Intrinsic value = (Sum of a company's assets, both tangible and intangible) – (Sum of a company's liabilities)

However, this method does not consider any growth prospects of the company. Hence, the intrinsic value calculated using this method will not aid you in making relevant comparisons and may also not give you a true picture of the actual value of the share.

●  Calculating the Intrinsic Value of Options

Considering investing in options, you must know how to calculate the intrinsic value. As options have concrete figures and metrics, there is no need to estimate any value that will help you arrive at the option's intrinsic value. The formula for calculating the intrinsic value of an option is:

Intrinsic value = (Stock price-option strike price) x (Number of options)

Let's take an example to understand this better.

If a stock is trading at INR 450 per share and you have four call options, you can buy 100 shares at every call at INR 400. You can calculate the intrinsic value of the share as follows:

(INR 450 – INR 400) * 50 = INR 2500

●  Dividend Discount Models

Different models factor in the cash element while calculating the intrinsic value of a share. The dividend discount model, or the DDM, is one of the most popular methods analysts use to arrive at the stock's intrinsic value.

The formula used to calculate the intrinsic value using this method is:

The Value of the Stock = EDPS / (CCE -DGR)

Where:

● EDPS is the Expected Dividend per Share
● CCE is the Cost of Capital Equity
● DGR is the Dividend Growth Rate

In the absence of any of these values, you will not be able to use the dividend discount model to calculate the value of the shares. Several dividend discount models, like the Gordon Growth Model, etc., can be used to calculate the present value of the stocks.

●  Residual Income Models

You can also use the residual income models to calculate the value of the shares. The formula that can help you calculate the value of the share is: 

V0 = BV0 + S (RIt / (1 + r)t)

Here,

BV0  is the existing book value of the company's shares

RIt is the residual income of the company for a particular period

And r is the cost of equity.

Here, the formula uses the difference between the EPS and the book value of the share to calculate the intrinsic value of the share.

Intrinsic Value vs. Market Risk

A Deep Dive into Options Intrinsic Value

When it comes to options trading, intrinsic value helps investors understand how profitable an option currently is—based purely on price. In simple terms, it shows how much an option is “in the money.”

A call option gives the buyer the right to purchase a stock at a fixed price (called the strike price), while a put option gives the right to sell. If the current market price of the stock is more favourable than the strike price, the option has intrinsic value.

• For a call option, this happens when the market price is higher than the strike price.
• For a put option, it's the opposite—the strike price must be higher than the market price.

If the strike price and market price are the same, the intrinsic value is zero—this is called an at-the-money option. And if the option is out-of-the-money, its intrinsic value also remains zero.

It’s important to note that intrinsic value only measures the gap between the market price and the strike price. It doesn’t include the premium paid or any time value. Those are covered under extrinsic value, which accounts for factors like time left until expiry and market volatility. The total price of an option—known as the premium—is a combination of intrinsic and extrinsic value.
 

Example of an Option’s Intrinsic Value

Call Option Example:

Suppose you buy a call option for ABC shares with a strike price of ₹2,200, while the current market price is ₹2,350.
The intrinsic value is ₹150 (₹2,350 − ₹2,200).
If you paid a premium of ₹40 when buying the option, your net profit at expiry would be ₹110 (₹150 − ₹40).

Put Option Example:

Now, imagine you buy a put option on XYZ with a strike price of ₹1,500, while the market price is ₹1,450.
Here, the intrinsic value is ₹50 (₹1,500 − ₹1,450).
If you paid a premium of ₹60, you’re technically in-the-money by ₹50, but still facing a loss of ₹10, since the premium was higher.
These examples show that intrinsic value only reflects the price difference, not your actual gain or loss. Real profit depends on both intrinsic value and how much you paid to enter the trade.
 

Conclusion

You can better comprehend the financial returns of a stock by looking at the intrinsic value of the share. To put it another way, it represents the true worth of a share. You must comprehend the use cases for estimating the intrinsic value if you are an active investor.

You can use any of the methods discussed above based on the values that are available to you. Remember that market and intrinsic value are not the same while understanding the stock's performance.