There are a couple of situations in investing when the difference between market and intrinsic value comes into play. For stock investors, market value shows up in black-and-white with the current share prices, while intrinsic value is a fuzzier concept. Option traders see the two values clearly, however, and the value difference in options shows how the two types of values relate.
A Stock's Worth
The market price of a stock is the result of the desires of buyers and sellers to either obtain or unload the shares. When buyers outnumber sellers, the price goes up. When the opposite happens, it goes down. When you multiply the share price by the number of shares outstanding, you get the market capitalization of the company. In contrast, intrinsic value would be the worth of the company based on calculations involving current and future profits, or the assets owned by the company. In a perfect world, the market value and intrinsic value would be similar numbers. However, investing is as much emotional as analytical, so this is not always the case.
Intrinsic Value Methods
Investors calculate the intrinsic value of a company to determine if the stock price is overvalued or undervalued. Intrinsic value methods include present value analysis of future profits or putting values on the tangible and intangible assets of the company. Determining the intrinsic value is a combination of analysis, mathematics and assumptions. Value investors look for stocks that are undervalued when the share price is compared to their calculation of the intrinsic value.
Function of Options
Stock options give traders the right to buy or sell specific stocks at preset prices. Since the value of an option is based directly on the price of the underlying stock, the difference between market and intrinsic value of options can be determined down to the penny. With an option, the intrinsic value is the resulting cash money if an option holder exercised the contract and then disposed of the underlying stock position at the current share price.
Options Pricing Concepts
For an option, the intrinsic value is the difference between the current share price and the price at which the option can be exercised. To illustrate, suppose a call option has a strike price -- the exercise price -- of $20, and the current share price is $22. Since the option owner could exercise the call and pay $20 per share, and then sell at the $22 market price, this option has an intrinsic value of $2. If the share price is below the strike price of a call option, the option has no intrinsic value. Put options work the other way around.
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