In finance, it is crucial to know the financial value of an asset. It is what informs the decisions of investors on when to sell or when to buy an asset and how much to pay for it. However, you can take several approaches to calculating value. Two widely used methods are the intrinsic value method and the market value method. Both of these methods are used to assess the value of many types of assets, such as stock options, real estate and cars. Although the general principles that govern each method does not change, variations in each method depend on the nature of the asset assessed.
Intrinsic Value as Replacement Value
The intrinsic value of a tangible asset is the sum of the value of its components. If you are assessing the intrinsic value of a car for instance, you would measure the sum of the value of the car's parts. If you are valuing the intrinsic value of a building, you can view it as the total cost of rebuilding the building on the same property.
Intrinsic Value of Options
When buying and selling call options on stock, the intrinsic value of call option is defined as the difference between its current price and its strike price, which is set by the issuer at the time of sale. For instance, if the current price of an option is $5 a share, but its strike price is $3, it has an intrinsic value of $2.
Fair Market Value
The fair market value of an asset is defined as the price it would sell at by a seller who wants to sell, but doesn't need to, to a buyer who wants to buy, but doesn't need to. This simple definition betrays the fact no easy way exists to calculate an asset's fair market value. It is an arbitrary decision based on factors such as desirability, use and scarcity. No single formula can calculate fair value, but in real estate, property assessors will look at the selling value of similar assets to estimate fair market value.
Intrinsic vs Fair Market Value
Value investors are always on the lookout to buy assets that trade below their intrinsic value, or to sell assets that have a lower market value than their current market value. For instance, when buying and selling stocks, their intrinsic value is the difference between their market value and the option price guaranteed by the stock option issuer. The fair market value of an asset is an arbitrary value that changes widely based on the offer and demand in the market. The intrinsic method, on the other hand, is less fickle and keeps much of its value regardless of the ups and downs of the economy as a whole and the industry economy in particular.
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