Intrinsic value definition
/What is Intrinsic Value?
Intrinsic value measures the worth of a stock option. A stock option gives its owner the right, but not the obligation, to purchase a security at a specific price over a predefined period of time. The concept is used in the recognition of the value of an issued stock option. The option issuer needs this information in order to recognize the compensation expense associated with a stock option.
How to Calculate Intrinsic Value
The intrinsic value of a stock option is calculated by determining the difference between an option's strike price and the current market price of the underlying stock, but only if the option is "in the money." For a call option, the intrinsic value equals the current stock price minus the strike price (intrinsic value = stock price – strike price), as it reflects the immediate profit if the option were exercised today. For a put option, the intrinsic value is calculated as the strike price minus the current stock price (intrinsic value = strike price – stock price). If the result is negative, the intrinsic value is considered to be zero, since an option cannot have a negative intrinsic value. This calculation helps investors understand the real, exercisable worth of the option, separate from its time value or premium.
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Example of Intrinsic Value
Luminescence Corporation is a privately-held company. It issues a $5,000,000 convertible debt instrument that can be converted to the company’s common stock in two years at a conversion price of $12 (which is also the current fair value of the stock). There is an additional provision in the debt agreement that the conversion price drops to $8 in 18 months if Luminescence does not complete an initial public offering by that date.
The intrinsic value of the conversion option is calculated as follows:
(Funding obtained ÷ Final conversion price) × Difference in conversion prices)
= ($5,000,000 ÷ $8) × ($12 - $8) = $2,500,000
Luminescence should recognize the intrinsic value of the conversion option when it issues the convertible instrument.