# Theories of Intrinsic Value

by Ben Taylor

Valuation is the process of determining what an asset is worth. Theories of intrinsic value in finance postulate that an asset's value comes from the asset itself, not from its market value or its book value. Theories of intrinsic value address derivatives such as stock options, equity such as a business's cash flow, as well as real estate. Other intrinsic value theories quantify an asset's value based on the time and resources involved with producing or acquiring it, regardless of other valuations.

## Derivatives

A derivative's intrinsic value is based upon its underlying asset. If a derivative -- such as a stock option or futures contract -- is in-the-money, the holder can can exercise it for a profit; if it isn't, the derivative has no intrinsic value. Two types of options exist: call and put; a call option gives its holder the right to buy 100 shares of a particular stock. A put option gives its holder the right to sell 100 shares. A call option's intrinsic value is the current value of its underlying stock minus the option's strike price -- which is the share price at which the holder can use her option. A put option's intrinsic value is the option's strike price less the current value of the stock.

## Discounted Cash Flow

Independent of its book value or market value, the intrinsic value of a firm's equity is calculated through a discounted cash flow (DCF) valuation. A DCF valuation computes a firm's annual projected cash flow for a number of years at its current value -- essentially as a quantification of potential performance. Using a firm's weighted average cost of capital (WACC) -- the return a firm must earn on the money it has borrowed -- DCF weights each annual cash flow projection to give it a current theoretical value.

## The Gordon Growth Model

The Gordon Growth Model is useful in calculating the intrinsic value of investments, such as a real estate investment trust. The model is a variant of the DCF model and calculates intrinsic value by discounting the investment's dividend payout in perpetuity. The formula divides an investment's annual dividend by the return the investor expects from the investment, then subtracts the expected constant rate of dividend growth, according to Q Finance. The resulting valuation quantifies the current value of future expected dividend payouts.

## The Labor Theory of Value

The Labor Theory of Value ascribes intrinsic value to an investment or product based on the time and effort required to produce or acquire it. For example, if a worker used \$10 in fuel and resources to produce a hammer worth \$50, the intrinsic value of her labor is \$40. This value stays constant despite demand for the worker's hammer, the passing of time or any other factors, according to the International Society for Individual Liberty.