Textbook Problem

What is a firm’s intrinsic value? Its current stock price? Is the stock’s “true” long-run value more closely related to its intrinsic value or to its current price?

Summary Introduction

To identify: The firm’s intrinsic value, current stock price and the relation of the stock’s “true” long run value with intrinsic value and its current price.

Intrinsic Value: An estimated value of the stock which can be determined considering on the exact risk and return. The intrinsic value can be predictable but not measured accurately. The intrinsic value can be calculated by professional analyst on the basis of the data provided by the company.

Answer to Problem 1Q

• Intrinsic value is an estimate of stock’s true value determined on the basis of risk and return data. Intrinsic value can be estimated only but it is not possible to measure it accurately.
• Current stock price is the actual price which is based on apparent but possibly mistaken information by the marginal investors. The marginal investors determine the actual price.
• The true long run value is related to the firm’s intrinsic value because the intrinsic value is a concept for a long term. The maximization of the intrinsic value will increase the average price for the longer time period to the maximum level.

Explanation of Solution

• Intrinsic value is estimated by the stock analyst as per available data of the risk and return.
• The current stock price is a market price of the stock which may be found on internet or in newspaper or through published sources.
• The maximization of shareholders wealth in long run is the main goal of the manager. As intrinsic value is a long run concept, it can be said that the intrinsic value is more related with the “true” long run value.

Conclusion

Therefore, intrinsic value is the estimated value of stock closely related with the stock’s “true” long run value and the current stock price is actual price of the stock.