Understanding Intrinsic and Extrinsic Value: An Overview

Sykes & Ray Equities (I) Ltd.

Disclaimer: This post is for educational purposes only. Markets are subject to risk, so please consult your financial advisor before making any investment decisions

One of the most important concepts to know is what intrinsic and extrinsic value are in finance and investment. Whether you are a seasoned investor or just trying to explore the market, knowledge of these two forms of value is very important when taking investment decisions. These two values come in handy in evaluating any asset, pricing options, or reviewing potential investments in the stock market, commodities, real estate, and more.

What is Intrinsic Value?

Intrinsic value is the real, intrinsic worth an asset has. It comes from a source independent of sentiments in the market or factors outside of it. Value derived from intrinsic worth comes from the attributes of the asset, often including financial health of companies, their assets, income, and growth prospects. In intrinsic value, for investors, determining how much an asset is actually worth is a method of judging if an asset is underpriced or overpriced relative to its real worth.

• In Stocks: This is a stock's inherent value and is determined, taking into account the basics of how that company is operating, like its earnings and revenue growth, profitability as well as market position. The best techniques to make an intrinsic value calculation is through the use of Discounted Cash Flow (DCF) analysis and with the Price-to-Earnings (P/E) Ratios are typically used to calculate intrinsic value.
• In Options: For options, intrinsic value is the difference between the strike price of the option and the current market price of the underlying asset. When the option is "in the money," meaning its strike price is favorable relative to the current price of the asset, it has intrinsic value.

Example: You may consider a stock undervalued if, having done all your research and calculated how much a company's stock should be based on its earnings, assets, and future prospects, you thought that the stock should be trading for ?120 but is trading at ?100. The intrinsic value of the stock would be that ?120.

With over 34 years of experience serving our clients, we offer personalised 1-on-1 consultations to help you understand market trends and invest in fundamentally strong stocks. Contact us at 022-61937300 or visit www.sre.co.in for more details. Invest smart with SRE.

What is Extrinsic Value?

Extrinsic value is also called time value or market value, representing the component of the price of an asset which captures external elements, like the market psychology, the expiration time for options, and volatility. In contrast with intrinsic value, extrinsic value changes with market conditions and, in most cases, depends on speculative pressure rather than real worth. It represents the potential for price movement in the future as it is possible to make more value out of this asset in the future.

• In Options: Carry an extrinsic value amount by which the total price of the option exceeds its intrinsic value. Such a value is influenced by factors like time to expiration, volatility, and interest rates. For instance, the longer the time until an option expires, the greater its extrinsic value because there is enough time for the underlying asset to move in favor of the option holder.
• In Stocks & Commodities: For stocks or commodities, extrinsic value is influenced by market trends, news events, investor sentiment, and speculation. The asset could be trading at a price higher than its intrinsic value due to hype, speculation, or external factors that change the market's perception of it.

Example: Take an example, say if the strike price is available at ?50, but currently it is at ?55, then here the option holds an intrinsic value of ?5, but considering months left in its validity, with extreme volatility in the market, it will be charged many times above ?5 through extrinsic value for an option based on potentiality for growth in stock before the deadline.

Key Differences Between Intrinsic and Extrinsic Value

Intrinsic Value: It is the true, intrinsic value of an asset, based on its core attributes, such as earnings, growth potential, or financial health. Intrinsic value is more stable and less affected by short-term market movements.

Extrinsic Value: It reflects external factors such as market sentiment, time to expiration, and volatility. It is influenced by speculative forces and changes rapidly with market conditions.

With over 34 years of experience serving our clients, we offer personalised 1-on-1 consultations to help you understand market trends and invest in fundamentally strong stocks. Contact us at 022-61937300 or visit www.sre.co.in for more details. Invest smart with SRE.

Why These Values Matter for Investors

The understanding of the difference between intrinsic and extrinsic value is very significant in your investment strategy. Here's why:

• Intrinsic value will help in assessing the underpriced or overpriced relationship an asset is worth compared to its true worth. With a focus on intrinsic value, you find opportunities to buy undervalued assets and make long-term investments based on sound fundamental analysis.
• In addition, extrinsic value can provide information about the short-term movements of assets. It is, therefore, a value that options traders should be familiar with to determine if they are trading options at a fair price or whether they are trading at a fair price relative to the future potential gains.

How to Apply These Concepts in Real Life

Intrinsic value aids long-term investors in making sounder decisions because of the value true to assets. Suppose I were considering investment in shares in the stock market; the intrinsic value computes the true value to advise if the company is low, and that's a buying chance.

For traders, especially for the option traders, the extrinsic value is essential. Time value and volatility, among others, have a major impact on option prices; therefore, one needs to calculate these elements to ensure winning trades.

Conclusion

With a growing complexity in finance and its environment, making an investment choice is always a daunting task. Knowledge of intrinsic value coupled with the extrinsic value of assets, will determine and distinguish true worth and that which appears but is only for show, both being equally valuable in different times for investors to chart their strategy.

Let's connect and talk about how understanding intrinsic and extrinsic value can improve your investment strategy!

With over 34 years of experience serving our clients, we offer personalised 1-on-1 consultations to help you understand market trends and invest in fundamentally strong stocks. Contact us at 022-61937300 or visit www.sre.co.in for more details. Invest smart with SRE.