“Price is what you pay; value is what you get.” Warren Buffett
“Don’t judge a company’s stock by its share price.” Many people incorrectly assume that a stock with a low dollar price is cheap, while another one with a four-digit dollar price is expensive. In fact, a stock’s price says little about that stock’s value. Moreover, it says nothing at all about whether that the market price of a company is headed higher or lower.
The most important distinction between the ‘market price you pay’ and the ‘intrinsic value you get’ is the fact that price is arbitrary and value is fundamental.
- Price is the amount paid for the product or service.
- Cost is the aggregate monetary value of the inputs used in the production of the goods or services.
- Value of a product or service is the utility or worth of the product or service for an individual.
To effectively deploy this strategy, it’s essential to find a company that you understand, that has solid fundamentals — then be patient and wait until the company’s stock price falls below its intrinsic value before you purchase the company.
Regarding ‘understanding’ a company, it’s important for investors to know how a company makes its money–revenue, profits and free cash flow.
At some point, a stock’s market price over the long term adjusts to its intrinsic value. This fact is how successful investors such as Warren Buffet have used to make billions over the long term.
“Finding differences between price and value is by far the most effective investment strategy”, writes Phil Townes, founder of Rule One Investing . “Not recognizing differences between price and value is also what causes many investors to lose their shirts, as companies are just as often overpriced as they are underpriced.”
How do you find companies that are on sale for less than their true value is to evaluate companies using a set of standards that look beyond the company’s current price tag. Phil Town call these standards the four Ms:
- Meaning,
- Moat,
- Management and
- Margin of Safety
The first step is to make sure you understand the company and the company you invest in has meaning to you as an investor. If it does, you’ll understand it better, be more likely to research it and be more passionate about investing in it.
The second step is to choose a company that has a moat. This means that there is something inherent about the company that makes it difficult for competitors to step in and carve away part of their market share.
The third step is to look at the company’s management. Companies live and die by the people managing them, and if you are going to invest in a company, you need to make sure their management is talented and trustworthy.
Finally, calculate the company’s intrinsic value and determine a margin of safety. Margin of safety is the price at which you can buy shares of a company, being more likely that you won’t lose money and have increased confident that you will make a good return on your invested capital.
When the market price of a company is lower than the company’s intrinsic value number, the company is deemed underpriced and represents a great investment opportunity.
“Leveraging differences between price and value is as simple as that”, said Town. “Find a company that you believe in, that has solid fundamentals — then wait until their price falls below their value. If you do this, you can buy companies on sale, sell them for their true value and make a lot of money in the process.”
The goal is to identify stocks that are undervalued—that is, their market prices do not reflect their true intrinsic value.
References:
- https://www.forbes.com/sites/forbesfinancecouncil/2018/01/04/the-important-differences-between-price-and-value/
- https://keydifferences.com/difference-between-price-cost-and-value.html
- https://www.investopedia.com/articles/stocks/08/stock-prices-fool.asp
The overriding goal is to help individuals learn how to successfully invest in assets, to build long term wealth and achieve lifetime financial freedom.
