The Difference Between a Stock's Value and Price
Value is a better measure for investors while price matters more to traders
We, the so-called “value investors” often find ourselves trying to resolve the differences between a stock's value and its price. If you have spent any time investing in the stock market, you will know that value and price are two different measures arrived at by different means but most of the time we might confuse and mix up “price as value”.
While fundamental factors influence stock prices over the long term, supply and demand rule stock prices in the short term. More buyers than sellers can mean the stock's price will rise, while more sellers than buyers indicate that the price will fall.
Whether there are more buyers or sellers on any day depends on many factors, such as:
1) Overall market trends
2) News, good or bad
3) Economy / Geopolitical Risk
4) Confidence or lack of it in the economy
5) Company news, such as earnings, financial issues or scandals which may move the price in the short term.
With regard to stocks, investors in the stock market typically determine a stock's value by looking at factors such as:
1) Earnings (past, present and, more importantly, future projections)
2) Market share
3) Sales volume over time
4) Potential and current competitors
5) A variety of metrics such as P/E ratio
In short, traders are more concerned with a stock's price and investors are more concerned with the stock's value.
Traders live on price changes, whether up or down. They make money by figuring out which way prices are going to move and taking a position so that they can profit if they make a correct trade.
Investors are more concerned with value since over the long term their assessment of the value will guide their decision to buy or sell their holdings.
Taking the long-term view doesn't mean to buy and forget because the market changes, and often quite rapidly. It's important for us to reassess their stock's value or portfolio on a regular basis. Hope by doing this, we will not end up selling the winner and holding on the loser ( loss aversion ).
Determining Intrinsic Value
Some analysts utilize discounted cash flow analysis to include future earnings in the calculation, while others look purely at the current liquidation value or book value as shown on the company's most recent balance sheet. Further difficulty arises from the fact that the balance sheet itself, since it is an internally produced company the document, may not be a completely accurate representation of assets and liabilities.
Determining Market Value
The market value is usually higher than the intrinsic value if there is a strong investment demand, leading to possible overvaluation. The opposite is true if there is weak investment demand, which can result in undervaluation of the company.
One of Warren Buffett's most famous quotes (via Benjamin Graham) is, "Price is what you pay; value is what you get." It's an idea that largely guides his investment decisions and one that he has used to achieve an unparalleled level of success. What exactly does this quote mean, though, and how can we use it to guide our own investment decisions? To answer that, let's take a look at the important differences between price and value.
Leveraging Differences Between Price And Value
Finding differences between price and value is by far the most effective investment strategy. 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.
So how do you find companies that are on sale for less than their true value? The answer is to evaluate them using a set of standards that look beyond the company's current price tag.
There are a variety of formulas and calculators you can use to calculate a company's intrinsic value. Calculating the value of a company could be an objective way like base on accounting figures from balance sheet ( PE/ PB / FCF / ROE/ Profit Margin / Sales Growth / Debts etc ) or subjective criteria like ( Moat / Management Quality / Venturing into new business/ M&A impact etc ).
But doing a valuation for a company is both science and art, is not just by punching in figures and calculating the financial ratios but also the “qualitative” type of analysis as above mentioned.
Below are the summary of the interview by Forbes with Prof Aswath Damodaran, one of the leading or experts in teaching equity valuation and corporate finance.
Enjoy reading :
Interview with Professor Aswath Damodaran on Valuation
Professor Aswath Damodaran is currently a Professor of Finance at NYU's Stern School of Business. He has been called Wall Street's "Dean of Valuation", and is widely respected as one of the foremost experts on corporate valuation.
Damodaran has published several books on equity valuation and corporate finance. His work has also been published in The Journal of Finance, The Journal of Financial Economics, and the Review of Financial Studies. Damodaran has been voted 'Professor of the Year' by Stern's graduating MBA class five times and has been awarded NYU's Excellence in Teaching and Distinguished Teaching awards.
What is the most egregious valuation mistake you most routinely see being made by investment professionals?
Aswath Damodaran, NYU Stern: The most egregious valuation mistake that I see investment professionals make is mistaking pricing for valuation. Most investment professionals don’t do valuation, they do pricing. What I mean by that is that you price a number to a stock based on what other people are paying for similar stocks. Any time you use a multiple comparable you’re not valuing the company, you’re pricing a company. Ninety per cent of the time, when someone says “I’ve valued a company at X”, I always have to stop and ask them, “What do you mean value the company?”. Most of the time when I extract the answer, the answer is that they’ve really priced the company. There’s nothing wrong with pricing. But it’s not valuation. Valuation is about digging through a business, understanding the business, understanding its cash flows, growth, and risk, and then trying to attach a number to a business based on its value as a business. Most people don’t do that. It’s not their job. The price companies. So the biggest mistake in valuation is mistaking pricing for valuation.
How do you approach valuing companies whose price seems to be more based on narrative and hype than hard numbers?
Damodaran: There’s an advantage in realizing that there are two processes at work. There’s a valuable process and a pricing process. The pricing process can be driven by mood and momentum, which doesn’t change the value of the company. But the price can then be a number very different than the value. The conundrum investors face is in valuing that company is that if the company has been priced, you can come up with a value very different from the price. Then the question is what do you do with that valuation. If the pricing process is strong enough, you can be right and go bankrupt being right on the company’s value, because the pricing process can keep pushing the price away from the value for extended periods.
How do you value companies similar to Tesla or Amazon, whose founder’s stories seem to be muddled with the companies’?
Damodaran: It is dangerous because people are unpredictable. It is better to have a company with a more balanced management team.
The difference between Tesla and Amazon, even though they both have strong founders, is that Jeff Bezos is not upfront and centre. How often do you see Bezos tweeting about an Amazon problem? He knows that for Amazon to be a successful company, he has to build a good management team. That’s what Tesla needs, a management team that is strong - and for Elon Musk to let go of some of the things that he’s trying to do. I think that it’s okay to be a founder driven company if you build in strong management. And while we talk about Buffett and Berkshire Hathaway, we forget that Charlie Munger was a counterweight to Warren Buffett. In a sense, Berkshire is a Warren Buffett company, but it isn’t entirely Buffett, it’s Munger, and it’s Jain, and this demonstrates that the key is having a strong team. That’s what I think separates founder run companies that survive and become great companies, and founder run companies that crash and burn with their founders.
What is the most contrarian valuation that you’ve published in your career? How did it turn out?
Damodaran: When Apple was at the peak of its glory in 2012, I chose to sell. And I chose to sell even though I loved the company. It was actually very difficult valuation to do because I was so biased towards Apple. And at that time everyone thought that Apple would keep going up because it had an incredible decade. If I were to pick a company where my valuation most went against the grain, it would be Apple in 2012.
What are your thoughts on the astronomically high private market valuations achieved by companies like Uber?
|image credit to investopedia.com|
There doesn’t need to be a fundamental rationale for value. All you need in the pricing game is someone else willing to pay a higher price for the company. As long as momentum is on their side, it’ll keep pushing the pricing up. It’s got very little to do with fundamentals, and everything to do with “is there somebody else out there who will pay me a higher price for this company”.
On ‘The Dark Side of Valuation’, you covered the risk of massively overvaluing young companies in young industries. Do you think that companies caught in the tech bubble have systematically been overvalued?
Damodaran: It’s a feature not a bug. It’s the nature of young companies and young markets, that you will overvalue them, because you’re looking at clusters of what I call overoptimism. Each cluster, be it the VCs and employees of a company think that they have the answers to the big questions. It’s how markets evolve, and I think that it’s a healthy process. I think that bubbles are not always bad, because they’re what allow us to change and move on. So I think that you can look at bubbles as a bad thing and try to make them go away, but I think that they’re a good feature of markets and allow us to shift from one business to another, from one technology to another.
So are they collectively overvalued? Yes. So what? There will be a correction, some people will lose their money. But as long as we are informed in our decisions, make our own, and are willing to look at the losses, things will be fine. This is not like the 2008 bubble. It is not existential. What made that bubble painful is that it happened with financial services, so dragged the rest of the world into it. This is a technology bubble, so I’m not going to wag fingers and tell people not to invest in it. It’s your money, and you’re entitled to invest it wherever you want.
What are the most important innovations in valuation methodology during your career?
Damodaran: Almost none. Valuation isn’t about methodology, it’s about adapting your valuation techniques to real-world challenges. I think in my lifetime, I’ve seen the world go from being a domestic company driven world to a multinational world. We have to think globally, which is one shift, You have to think about not just the risk premiums from the market you’re in, but also the risk premiums of the rest of the world. That’s one big difference.
The second is, we’ve lived through a decade of low-risk premiums. We’ve had to learn to be much more careful about risk premiums, currencies, and how we use them in valuations.
And third, we live in a world where companies’ life cycles have shortened. Yahoo went from being a startup to an incredibly successful company to no company at all in a period of 25 years. As lifecycles shorten our valuation approaches have to adapt to those.
‘--- End of Interview ----