The difference between price and value
And why it matters
In this piece we are going to be covering three main points.
Mr. Market
Margin of safety
Opportunity cost
If you have ever read any Warren Buffet or Benjamin Graham, (the father of value investing, and also Warren’s mentor) than you have likely heard of the Mr. Market allegory. If not, lucky for you, I was planning on explaining it below.
Mr. Market is a moody investor, who seems to come around often. At times he is very pessimistic and can’t believe that anything positive can happen. When he is in this mood, he is willing to sell you his assets for very cheap and is also asking a cheap price to buy your assets. And sometimes he is overly optimistic and can’t wrap his head around anything negative happening. During this time, he will be asking very expensive prices to buy his assets, and likewise offering expensive bids to buy yours. For assets like stocks, Mr. Market will offer you a different price more than 250 days of the year. What you need to remember is that Mr. Market is not telling you the value of the assets; he is simply just offering prices. If you let your emotions do the thinking, you will let Mr. Market get in your head. The stock market can be tough because you see 250 different prices for the same asset throughout the year.
Now let’s say you owned a farm, and you knew the value of the farm was roughly $5 million. If your neighbor walked over and offered you $2 million for your farm, would you be worried? Let’s say your neighbor owned a farm worth roughly $5 million as well. One day he walked over and offered you $2 million for his, would you accept? The bottom line is if you own a farm, you’re not going to see 250 different prices offered in a year like the stock market. You know the value of your farm is around $5 million and you wouldn’t accept an offer worth significantly less. You might consider taking an offer worth significantly more. Think of your assets as a farm with an approximate value. If your neighbor actually came by 250 days a year to try and buy your farm you might end up just pulling out the shotgun. All of the price movement you see in the stock market is simply just noise. It is only telling you the prices currently being offered by the market, depending on its mood. Value has to do with the amount of assets, debt, cashflows and growth of future cashflows of the business. A true gold mine is buying a great business with great financials and growth prospects, when Mr. Market is pessimistic and offering you a price much cheaper than the value. DON’T CONFUSE STOCK PRICE WITH VALUE.
The second topic we will discuss is margin of safety. Let’s say there is a company you are thinking about buying shares of. You are super excited about how much money it is earning and think that it could grow like crazy! You really want to own this company. You would feel comfortable buying shares when the company is valued between 40-45 billion dollars. In other words, you think the value of the company is approximately that. Let’s say that currently this company is trading at a valuation of $65 billion. It’s not fairly valued in your eyes, but you decide to buy anyway because you just can’t hold back your excitement. The market has high expectations for the company as well, thus the expensive asking price. Let’s say that 2 years later the company has now reported 8 quarterly earnings since you bought. These earnings reports weren’t necessarily bad, but they weren’t as great as the market was expecting. And although the company has reported decent earnings the stock hasn’t moved up in price at all. That’s because when you bought, the market was pricing in a ton of growth that didn’t end up happening. And now the market is pricing it as if it’s not going to grow that much. There was an error in the growth forecast when you bought. And what’s important is you didn’t leave yourself any room for error. Even the best companies have hiccups. If you’re buying at such high prices, any errors in your forecast will hinder your investment performance. What you want to find is opportunities where even when you factor in some errors and slower than expected growth, you’re still likely to make a good return on investment. Let’s go back in time and say that company that you really wanted to own and felt comfortable buying between 40-45 billion dollars was actually trading at $25 billion. Now even if the company doesn’t grow as fast as you expect, even if it runs into some short-term headwinds, you feel you are still likely to make some good money. Well let’s say you buy it at a $25 billion valuation thinking it could easily be valued at $40 billion. And now let’s say that the company actually does grow its earnings like you thought it could. Now you're looking at a fantastic investment. Giving yourself a margin of safety means even if things don’t go as perfect as you envision, it still seems like a good deal. And if things do go as expected, then it’s a great deal. When you pay too much for a business then you’re giving yourself no margin of safety, and no room for error. If things don’t go as expected, then you could be looking at a bad investment. GIVE YOURSELF A MARGIN OF SAFETY, BECAUSE WE DON’T HAVE A CRYSTAL BALL. WE CAN’T KNOW WHAT THE FUTURE HOLDS.
The third topic we will discuss is opportunity cost. Put simply, the cost of putting your money here is it’s not there. You could put every dollar you have into a high yield savings account earning you 3.5% annually, and that’s fine. But the cost of putting all your money there is you don’t have any money in the S&P 500 index that earns on average 10% a year. The cost of buying a business that Mr. Market is asking a steep price for, with no margin of safety, is your money isn’t going into an equally great business that Mr. Market isn’t asking such a steep price for, that has a margin of safety. If interest rates spiked up to 15% and you could get savings rates or bonds around that rate, then there would be an opportunity cost to being in stocks. If you could use a savings account or buy high grade bonds and earn 13% annually (more than the average return of the S&P 500) with little to no risk, why would you risk your money buying stocks trying to earn a few extra percent a year. Before putting your money anywhere think about your other investment options. If your 17th best investment idea doesn’t even come close to your top 5 ideas, then just double down on your best ideas. The cost of putting your money anywhere is it’s not anywhere else. BE VERY INTENTIONAL ABOUT WHERE YOU PUT YOUR MONEY. LET YOUR MONEY WORK HARD FOR YOU, NOT THE OTHER WAY AROUND.
I will be writing another newsletter later this week going more in depth on how I personally find approximate values for investments. There is no one correct way to do it, and there is no way to know the exact value of anything for certain. But we can do some things to give ourselves a better chance of being generally right. Understanding the 3 concepts above will definitely help guide us in the right direction.