The Difference Between Value and Price
Updated: Mar 7, 2021
There is a difference between value and price. Understanding this is key to investing.
Exactly what makes price and value different is hard to describe so I'll do it in a non-academic way.
If somebody came to you and asked you how much you'd pay to buy their car wash what would you want to know? You'd probably want to know what the building and equipment could be sold for. You'd also want to know if the business had any debts, how much money it made, and how consistent it was. Let's summarize this.
So let's say we ask the seller and they tell us what we want to know.
1) Assets = $100
2) Liabilites = None
3) Earnings = $100 a year
4) Risk = Pretty consitent, usally between $90 and $110 a year.
Let's start with the obvious, we would be willing to pay 50 dollars because then we could just sell the assets and walk away with a profit, a no-brainer. We also wouldn't pay a million dollars for an extra hundred dollars a year.
We decide to go to our local bank to see how much they will offer us for our deposit. The banker offers us 5% a year and assures us that the investment is very low risk. Now we know that we will need to make more than 5% on our investment in the car wash, otherwise, we'd be better off putting our money in the bank.
We determine that an 8% return on our money compensates us for the extra risk we will be taking on. We divide 100 / 8% to arrive at a value of $1250. (discounting future earnings)
We decided to purchase the business so that we can take the profits and make a return on our investment. We understand a business as something that makes money. We are after the free cash flow.
Price is a different thing. Imagine the seller came to you and asked you to pay $3,000... you would say no. Even if you felt these car wash things were gonna be all over the place and everybody you knew was crazy about car washes you would not pay $3,000.
You also wouldn't pay the $3,000 because you were hoping that the hype over car washes would continue and you could sell it to somebody else for an even higher price. Instead, you would imagine yourself owning the business in full and not being able to sell it off quickly. You would realize that it's the earnings power of the business that really mattered.
Too often I hear investors go on and on about a new technology or trend. They talk endlessly about how people who bought before them made a return of x% and so on and so on. In their mind as long as things go well for the company the price will go up. They think the stock market works like that, whoever can say what company is gonna grow is gonna get rich. It's not that simple.
Stocks are forward-looking, they reflect data. That means that just because you think nuclear water heaters are the way of the future doesn't mean the company is a good investment. It's possible that in the stock price the assumption of a total nuclear water heater takeover is already priced in three times over.
What you need to do as an investor is learn to express your views in terms of valuation and then compare them to what the market offers. That way you can take all of your ideas and views and put them into a usable metric known as value.
Valuation doesn't limit your creativity or take away your ability for big thinking. Valuation allows you to take ideas and make them usable.
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