Question

Is it better for a firm's actual stock price in the market to be under, over, or equal to its intrinsic value? Would your answer be the same from the standpoint of stockholders in general and a CEO who is about to exercise a million dollars in options and then retire? Explain.

Answer 1

Intrinsic value is basically the value derived from the fundamental analysis of stock and its also called book value. Its the value which the stockholder receive when a company is liquidated. On the other hand market value is the value at which a stock is traded in the market. If the market value is higher than the intrinsic value then the stock is said to be over-valued and if the market price is lower than the intrinsic value then the stock is said to be undervalued. Market value is basically derived from demand and supply relationship of a stock. If the demand is high then the market value high and if the demand is low then the market value is low. On the other hand, if the market price is equal to the intrinsic value then the stock is said to be in equilibrium. Management of a company always seeks to maintain the two values in equilibrium. So if the market price is lower than the intrinsic value then the stockholder may expect that the management will do the corrective action to bring the two values equal i.e. he may expect the market price to rise in the future.  

From a stockholder's point of view, if the stock is overvalued then he may not consider buying more of that stock and if the stock is undervalued then he may not consider selling that stock. This is a general thinking of stockholders in the market but when we consider buying a particular stock then our aim should be to maximise our gains i.e. to purchase at a lower price and sell at a higher price. Rather than looking at under-valuation and over-valuation of a stock we should always give a thought on buying at a lower price and selling at a higher price so that our profits can be maximised.

From a CEO's point of view who is going to retire and at present considering to put his millions of dollars in options, since its the price he will get when he exercise the option. Its always better that the market price is more than the intrinsic value so that he may exercise the deals and retire with hefty sum of money.