The market value of an asset is the price at which it bought/sold in the marketplace.
The intrinsic value of an asset is the value that an investor with full knowledge about the asset’s characteristics would place on it.
In an efficient market, market prices closely reflect intrinsic value. In inefficient markets, active investors look to buy/sell securities whose intrinsic value differs from market value.
Since it is impossible to accurately predict all the characteristics of an asset, intrinsic value is estimated. Valuation techniques like discounted cash flow models have been developed to arrive at intrinsic values but they all require some judgment regarding timing, magnitude, and riskiness of the future cash flows. The more complex an asset, tougher it is to find its intrinsic value. Also, the intrinsic value may keep changing as the information related to asset may change
Check your concepts:
(47.3) If a security is overpriced then its:
(a) market value is equal to its intrinsic value
(b) market value is greater than its intrinsic value
(c) market value is less than its intrinsic value
(47.4) Assume that the market for an asset is efficient. You find out that the asset is undervalued in the market as per your intrinsic value estimate. The most likely conclusion is that you have:
(a) overestimated the asset's risk and correctly estimated the future cash flows
(b) underestimated the asset's risk and correctly estimated the future cash flows
(c) overestimated the asset's risk and underestimated the future cash flows
Solutions:
(47.3) Correct Answer is B: As the security is overvalued, its market value has to be greater than the intrinsic value.
(47.4) Correct Answer is C: You have found the asset to be undervalued. That means that your intrinsic value is greater than the market value of the asset. If the future cash flows are estimated correctly then the intrinsic value can be higher only when the asset's risk is underestimated. Both overestimating the asset's risk and underestimating the future cash flows will lead to a decrease in the intrinsic value.
