Intrinsic value
Also written Fundamental value
What an asset is actually worth — the present value of the cash it will generate over its remaining life, as against whatever price the market is quoting today.
In plain language
Price is what the market says. Intrinsic value is what the thing is worth. Research exists because the two differ.
Warren Buffett's definition is the one the workbook uses: the discounted value of the cash that can be taken out of a business during its remaining life. Not the cash it earns on paper, not what somebody might pay for it next year — the cash an owner could actually remove.
How it works
Every intrinsic valuation needs three inputs, and the answer is only as good as the weakest of them:
- How much cash, in each future year
- For how long, and at what growth rate after that
- At what discount rate — which is the return an investor demands for taking this particular risk
The third input does most of the work. Because the cash flows are discounted, a change of one percentage point in the discount rate can move the answer by 15–20% on a long-lived business. Two honest analysts can value the same company 40% apart without either making an arithmetic error.
A worked example
A toll road concession has 18 years left and collects about Rs 95 crore a year in cash after all costs and tax. Assume, for simplicity, flat collections and a discount rate of 11%.
The present value of Rs 95 crore a year for 18 years at 11% is:
95 × [1 − (1.11)^−18] ÷ 0.11 = 95 × 7.70 = Rs 732 crore
If the market values the concession at Rs 560 crore, an analyst has a case: roughly Rs 172 crore, or 31%, of margin of safety.
Now change one assumption. At a 13% discount rate the same cash flows are worth Rs 649 crore; at 15%, Rs 580 crore. The market price stops looking wrong. Nothing about the road changed — only the rate at which its cash was discounted.
Why NISM asks about it
Chapters 3, 4 and 10 all turn on the price-versus-value distinction, and Chapter 10 builds the discounting machinery. The examinable idea is that intrinsic value is an estimate produced by assumptions, not a fact to be looked up — which is why research reports must disclose their assumptions.
Common exam traps
- In a derivatives paper this word means something else. Series I, IV, VIII, XVI and V-D use intrinsic value for the in-the-money part of an option premium — how much a strike is worth if exercised now, with the rest being time value. That is a different quantity from the discounted value of a business on this page, and the option sense is what the STT and CTT exercise rules are computed on. Read which paper the question comes from.
- Intrinsic value is not book value. Book value is historical cost less depreciation; intrinsic value is discounted future cash.
- It is not a single number. Treat it as a range, and say so in the report.
- A stock trading below intrinsic value is not automatically a buy — it can stay cheap indefinitely. That gap is a reason to look, not a reason to own.
- Precision is not accuracy. A valuation quoted to two decimal places built on a 20-year growth guess is false confidence.
Where this is taught
- Series XIX-C · Chapter 3: Concept of Informational Efficiencyintroduced here
- Series I · Chapter 4: Exchange Traded Currency Optionsintroduced here
- Series V-D · Chapter 16: Introduction to Optionsintroduced here
- Series XVI · Chapter 4: Commodity Optionsintroduced here
- Series XV · Chapter 3: Terminology in Equity and Debt Marketsintroduced here
- Series VIII · Chapter 4: Introduction to Optionsintroduced here
- Series XII · Chapter 2: Securities: Types, Features and Concepts of Asset Allocation and Investingintroduced here
- Series X-A · Chapter 8: Investing in Stocksintroduced here
- Series IV · Chapter 4: Exchange Traded Interest Rate Optionsintroduced here
- Series V-D · Chapter 21: Exchange Traded Interest Rate Options
- Series XV · Chapter 4: Fundamentals of Research
Related terms
- CAPMA model that prices the return an investor should demand from a share: the risk-free rate plus beta times the market risk premium.
- Discounted Cash FlowA valuation method that estimates the cash a business will generate in future years and converts each year back to what it is worth today.
- Free Cash Flow to EquityThe cash left for shareholders after operating costs, tax, capital expenditure, working capital needs and all payments to lenders — what could be paid out as dividend without harming the business.
- Margin of safetyThe gap between a security's estimated intrinsic value and the lower price paid for it — the cushion that protects the buyer when the estimate turns out to be wrong.
- SpeculationTaking on risk not commensurate with the return sought, in the hope of a large gain, with minimal research into what the asset is actually worth — the opposite of investing, and not merely the short-term version of it.
- Option premiumThe price an option buyer pays the seller for the right the contract carries — non-refundable, and made up of intrinsic value plus time value.
- Return on EquityProfit after tax as a percentage of shareholders' net worth — what the company earned on the money its owners have left in it.
- Price to Book ValueShare price divided by book value per share — how many times the accounting net worth of a company the market is willing to pay.
- Dividend Discount ModelA valuation that treats a share as worth the present value of every dividend it will ever pay, discounted at the return an equity investor demands for holding it.
- Wasting assetAn option, whose time value shrinks towards zero every day it is held and is worth nothing at expiry — so an option buyer loses money simply from the passage of time.
- Call optionA contract giving its buyer the right, but never the obligation, to buy the underlying at a fixed strike price — so the loss is capped at the premium and the gain is not.
- Put optionA contract giving its buyer the right, but never the obligation, to sell the underlying at a fixed strike price — insurance against a fall, bought for a premium.
- MoneynessWhether exercising an option right now would give the buyer a positive, zero or negative cash flow — classifying it as in the money, at the money or out of the money.