101 Concepts for the Level I Exam

Essential Concept 42: Intrinsic Value and Sources of Perceived Mispricing

Intrinsic value is the true or real value given a hypothetically complete understanding of the asset’s investment characteristics. Intrinsic value might be different from the current (market) price of an asset.

Perceived mispricing is the difference between the estimated intrinsic value and the market price of an asset. It can be expressed as:

V_E – P = (V – P) + (V_E – V)

Interpretation:

The first component is (V-P) is the true mispricing or market error. It is the difference between the unobservable intrinsic value V, and the observed market price An analyst exploits the mispricing if it arises from the first term as it contributes to the abnormal return.
The second component (V_E– V) is the error in the estimate of the intrinsic value or analyst error. It is the difference between the valuation estimate and the unobservable intrinsic value. The lesser the second term, the better it is for the analyst.

For active investing to be successful, an analyst’s estimates must be different from consensus estimate and must be correct.