BTI Questions: What Is Intrinsic Value?

Mon, Sep 10, 2012

Budget Travel Advice

We’ve been getting some mail from startups intending to strike it big and live a Budget Travel lifestyle. In our first of many basic financial lessons, Michael’s going to explain the concept of Intrinsic Value, as well as how you can Calculate the Intrinsic Value of a Business.

There are two values in the world of business – intrinsic and book value. The intrinsic value is also known as the market value. The book value is included in the intrinsic value, along with other factors, such as brand name and other tangibles. The book value is a firm’s liquidation value. In order to find out intrinsic value, liabilities are subtracted from assets. However, it can be difficult to calculate the intrinsic value, as a way of bridging both market and book value is needed. The price-to-earnings ratio (P/E) is the metric that is most commonly used for this purpose.

An Overview of Intrinsic Value

In other words, intrinsic value is the actual value of an asset or a company, based on an implicit perception of the asset or company’s true value. This includes every aspect of the business, in regard to both intangible and tangible factors. Unlike current market value, intrinsic value might or might not be different. Various analytical techniques are used by value investors to determine the approximate the intrinsic value of securities.

For call options, the variation between the price of the underlying stock and the price of the strike is the intrinsic value. For put options, the price of the strike and the price of the underlying stock is the intrinsic. Similarly, when it comes to both calls and puts, the intrinsic value is usually zero if the value of the respective difference is negative.

How to Calculate a Business’ Intrinsic Value

1. In the off chance that you want to calculate your… um… conglomerate-sized independent business, you would do the following. First of all, before the intrinsic value of a business can be calculated, the market price of the stock has to be obtained. The market price of the stock can be found performing a search on Google, MSN or Yahoo! Finance. Even a quote can be obtained from a broker. For now, let’s assume that the market price of your stock is $20.

2. Next, the most-recent earnings-per-share figure has to be determined. The earnings for every share figure can be found on the statement of income (or your… um… PayPal printouts), which can be obtained from the annual report. Typically, the annual reports of companies are reported on their website (ahem… typically). If not, the investor relations department of the company can be contacted and can be asked to send the annual report. It can also be assumed that the $2 is the most-recent earnings for every share for this year.

3. Now, the P/E value should be calculated. The price of one share should be divided by earnings for every share share. For instance, in this case, $20 will be divided by $2, so the P/E value will be $10.

4. The average P/E ratio for similar companies in this industry will also have to be calculated. It can be assumed that 20 is the average P/E ratio.

5. Finally, the intrinsic value of the business is… calculated! Since the company has a lower P/E ratio in comparison to the industry average, so most probably the company is has an undervalue in the market. The earnings for every share should be multiplied by the industry’s average P/E ratio, which will specify how the company will be valued. In this case, $2 will be multiplied by 20, which means the $40 is the intrinsic value of the company.

If you’d like to learn more about intrinsic value, please check out Clime, Australia’s highly-esteemed fund manager.

CC Skidder

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