Option Intrinsic Value Explained

The concept of intrinsic value in finance

Intrinsic value is a term frequently used for options and stocks, but it can be applied to any asset. As a financial term, intrinsic value of a security or asset describes the value that is contained in the asset itself. Intrinsic value is often referred to as fundamental value or fair value.

In general, intrinsic value of an asset is calculated by adding up all future income that is expected to be gained from the asset. All future cash flows must be discounted to the present value.

Intrinsic value is a different term from market value. Market value (or market price) is how much people are willing to pay for an asset and it is derived by the interaction of supply and demand (it does not necessarily equal the value contained in the asset).

Intrinsic value of companies and stocks

Intrinsic value (or fundamental value or fair value) of a company is usually calculated by summing up all future cash flows to its owners (typically dividends). All cash flows must be discounted to the present value using the required rate of return.

Intrinsic value of a stock is calculated by dividing intrinsic value of the company by the number of shares.

For complex assets like companies (or their shares of stock) different people may have different opinions regarding how much the intrinsic value is. There may be multiple different methods of calculating intrinsic value of an asset, all leading to different results. The tricky part of intrinsic value calculation is estimating the parameters. After all, who knows what the dividend will be in 5 years?

Intrinsic value of an option

For options, intrinsic value is the value by which an option is in the money. In other words, it is the value you would gain if you exercise the option immediately (for American options). Intrinsic value is one of the two components of an option’s total market value or market price (the second component is time value).

Intrinsic value is determined as the difference between an option’s strike price and the market price of the underlying security. For call options, intrinsic value is calculated by subtracting the call option’s strike price from the market price of the underlying asset. For put options, you subtract the underlying asset’s market price from the put option’s strike price. Intrinsic value of an option can’t be negative – for out of the money options it is zero.

For more detailed explanation and examples of intrinsic value calculation see intrinsic value of call options and put options.

Other meanings of intrinsic value outside finance

The meaning of intrinsic value in numismatics:

The value of the metal (e.g. gold or silver) in a coin, irrespective of the coin‘s market price or value for collectors (the logic is the same as option’s intrinsic value as opposed to option’s market price).

The meaning of intrinsic value in ethics (extract from Wikipedia article Intrinsic value (ethics):

Intrinsic value is an ethical and philosophic property. It is the ethical or philosophic value that an object has “in itself” or “for its own sake”, as an intrinsic property. An object with intrinsic value may be regarded as an end or end-in-itself.

It is contrasted with instrumental value (or extrinsic value), the value of which depends on how much it generates intrinsic value. For an eudaemonist, happiness has intrinsic value, while having a family may not have intrinsic value, yet be instrumental, since it generates happiness. Intrinsic value is a term employed in axiology, the study of quality or value.

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