One of the most important concepts to grasp as a value investor is one that is perhaps not that intuitive to everyone. That concept is that the price of a stock and the value of a stock are two different things, and they are not necessarily equal – in fact they almost never are!
This is important, because value investors are interested in buying companies when the price is less than it’s true value. In other words we are bargain hunters, and seek to buy at the lowest price possible. But what exactly do we mean when we say that price is not the same as value? When IBM is trading at $60 per share, doesn’t that mean that it’s worth $60? The answer is no – let’s see why.
To better understand this concept, let’s first look at an analogy. You head down to the electronics store one day, and there on display is a beautiful brand new big screen TV. The price tag: $5,000. Would you buy the TV at that price? Let’s look at the factors you might consider.
- Do you already own a TV?
- What is the condition/quality of your current TV.
- Does the new TV have features that your current TV doesn’t have?
- What is the warranty?
- Do you even watch TV?
- Is this a 2nd or 3rd TV for your household?
- Is it big enough / too big?
There are potentially many more factors but you get the idea. There are many considerations to determine if paying $5,000 for that TV is worth it. Next week you head back to take another look and there’s a huge blowout sale. That TV is now selling for $1000! Do you buy it now? Let’s say you do. What happened to make you purchase it at $1,000 and not at $5,000? Somewhere within that price range of $1,000 – $5,000 was a magic number. That number is the value that the TV was worth to you. You may not know exactly what that number is, but you know that $1,000 is less than the value you placed on it, and so you decide to buy. If we want to put a number on it, you need to ask yourself this question, “What is the most I am willing to pay for this TV?”. You might answer $2,500. If you value the TV at $2,500 then buying it at $1,000 is a real steal. What if you valued it at $1,100 though? It’s still less that what you think it’s worth, but with only a $100 differential it might not be as attractive. This is an important concept that we come across in value investing: The larger the discount from true value, the more attractive the purchase becomes.
Let’s look at a second concept, and this is key: The price of the TV fluctuated wildly, all the way from $5,000 down to $1,000. But the value of the TV remained the same (or close to it). Assuming that your financial and personal situation didn’t substantially change in that one week between visits to the electronics store, you probably maintained that same $2,500 value on the TV. The fact that the price dropped 80% didn’t affect what you considered to be the true value!
The final concept to get a handle on, is that different people value things differently. This only makes sense – the value we determined for the TV was based on our own personal situation. Someone who doesn’t own a TV at all would probably be willing to pay more for that TV than someone else who has a big screen TV in every room of the house! That TV to us might be worth $2,500 but there are probably plenty of people snapping it up at it’s original price of $5,000 and many more who still wouldn’t even buy it at the $1,000 sale price.
Applying price and value theory to the stock market
It’s these differences in opinion on value that cause the price of stocks to fluctuate with such regularity. Stock prices don’t move arbitrarily. They move because of an imbalance between the number of people and price that people are willing to buy a stock, and those who want to sell. Every trade on the stock market involves both a buyer and a seller. Despite the price being exactly the same for both parties, the buyer believes the price is too low and is going to go up, while the seller thinks the price is too high and is going to go down.
Just as with the TV analogy, there are many factors that affect investor’s perceptions of whether the price of a stock is too high or too low.
- Earnings (both real and estimated future earnings)
- Indebtedness (and the company’s perceived ability to repay those obligations)
- Management competency
- Potential legal issues
- New or improved products (and their perceived effect on future earnings)
- Macroeconomic factors (will the country go into recession and people stop buying this company’s products?)
And just like buying that new TV, we as value investors need to assign what we believe to be the true value of that company’s stock before we make a decision to enter a position. Today, Coca Cola is trading at $36.95 per share. If we run our numbers and determine that Coke is truly valued at $50 / share we should buy at this price. On the other hand, if our calculations tell us that it’s only worth $20 / share then we should hold off until price drops to a more reasonable level. This is the essence of value investing, and it is this difference between the concepts of price and value that is the cornerstone of the investing strategies we use.
One final example: Selling dollar bills for 50 cents
To really drive this one home, let’s look at one more very simple example, this time using something where price really DOES equal value – the one dollar bill. Paper money (or coins for that matter) are guaranteed by the government they’re backed by to always be worth the face value printed on them. That is to say a one dollar bill is guaranteed to be worth $1. What if there was a billionaire who woke up one morning in a charitable mood and decided to sell her fortune. She went to the bank, withdrew all her money in the form of one dollar bills, and proceeded to put them up for sale – at a price of 50 cents each. How many should you buy?
As many as you possibly can of course! In this case, there is no guesswork as to the true value of the commodity. Since we absolutely know for certain that a one dollar bill has a value of $1, any opportunity to buy for less than that represents an immediate gain to our net worth. This is exactly what we’re trying to do as value investors with individual stocks. The only difference is that it is not always so obvious what the true value is. Our job is to nail down that value to the point where we’re almost certain we’re correct. In the dollar bill example we were 100% certain of the value of the commodity. We will never be 100% sure on stock valuation, but we might be 70%, 80%, or in some cases even 90%. We attempt to buy stocks that trade below this estimated value, after also applying what’s called a margin of safety to take into account the fact that we’re not 100% sure our number is correct. This is the true goal of value investing – buying a $100 stock for $50.