The cheaper it is, the better value it is. Right?
A matter for some confusion, particularly among those new to stock investing, is the question between price and value. So used to regarding price as a measure of value in everyday life, it is sometimes easy to believe that the same is true when dealing with shares. It isn’t.
It is easy to compare the price of, say, a liter of milk between supermarkets and come to the conclusion that the one selling at 50 cents is far better value than the one at $1. Often this conclusion will be drawn without regard to outside factors, such as brand, for example, or perhaps the cost of gas to travel to the supermarket with the lower price milk. Maybe parking at the cheaper supermarket is chargeable, too. Combining all these factors, does the milk at 50 cents really work out to be better value despite the obvious lure of the cheaper price?
Moving to a large ticket financial item, rather than liters of milk, the housing market is a clear indicator of the difference between price and value. Measured as a non-financial asset, the value of a roof over one’s head is, generally, the same everywhere. It brings comfort, solidity, and assurance. A home is a place to keep one’s belongings safe, and to relax, dine, sleep, and play. The value of this is the same to all home-owners. However, the price of a home varies greatly from area to area, region to region.
Too often, however, individuals are concerned with price rather than value, seeing price as a measurement of value. Price is the amount one pays, value is much more complex.
Price is absolute
The price of a stock’s shares is easily measured. It is there, in black and white. It is quoted on a second-by-second basis during the trading day, and is quite simply the number at which buyers and sellers are willing to transfer shares between them.
There are many factors that determine price, though ultimately price comes down to one thing: supply and demand. Oversupply will cause a share price to fall, and increased demand will cause a share price to rise. This phenomenon is seen in everyday life, of course, but bought home to be true when big events cause major price shifts. In 2008, mass homes foreclosures caused the housing market to collapse: prices fell across the board as houses for sale flooded the market. Supply went through the roof, demand fell away (because of funding and mortgage issues) and prices dropped.
In the stock market, willingness to buy and sell shares is affected on a daily basis by many outside factors – that is factors that, perhaps, don’t directly impact on a company, but may temporarily, at least, affect its share price. These pricing factors include:
- Market trend
- Economic issues
- Political news
- Sectorial effects
All of these issues will affect how traders and investors feel about owning shares at any given and specific time. They are broad based factors that affect trading sentiment. Sure, the state of the economy will cause share prices to rise or fall, but in general this will be across the board. There will be no consideration given to how individual companies manage the broader economy at any given specific moment (and certainly not on first movement). Such consideration is given over a longer period of time, by a company’s valuation, not its share price.
Related: How to Pick Good Dividend Stocks
Value is Relative
Where price is absolute, value is relative.
When considering stock investing, fortunately there are many calculations that can be used to determine value.
The first, and arguably most important of these, is earnings. The profit that a company makes will determine its dividends, internal investment, future growth, hiring and firing policies… in fact everything a company does hangs off its earnings. So what is better value, the company that makes $1 million and has shares priced at $1, or the company that makes $1 million and has shares priced at $2? Many would say the former, but consider that there are 3 million shares in issue in the first company, and only 1 million in the second. Now, the value of the companies stands at $3 million and $ 2 million and yet both companies make the same profits. Relatively, the second company would be better value, even though its share price is higher.
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Other ways in which company valuation can be derived include measuring the following:
- Market Share
- Costs and Expenses
- Cash Flow
There are a whole host of ratios that can be calculated to measure value relative to other companies, and the market, and these include:
- Earnings per Share (EPS)
- Price to Earnings (P/E)
- Price to Earnings Growth (PEG)
- Return on Equity (ROE)
- Return on Invested Capital (ROIC)
- Dividend Yield
Understanding the difference between price and value presents market opportunity
A stock’s price should, more or less, reflect the value of that stock. In a completely efficient market, this would be true at all times. However, markets are not efficient, and this fact is what creates investment and trading opportunity.
Share prices move every day, valuations move a whole lot slower. For any number of reasons, stock prices could fall, or rise, by several per cent overnight. Often, these moves may have little to no real bearing on the longer term valuation of a company’s shares. When large market moves like this happen, an investor will look at the move and figure if anything fundamental has changed that will alter the outlook of specific companies or sectors. If the answer is ‘no’, then the value of individual stocks will be out of sync with stocks prices. An opportunity to buy or sell for long term profit has arisen. It may take weeks for the market move to correct itself in individual stocks, but the investor is sure of the long term viability of his trade.
Related: The Basic Tenets of Investing
Shorter term swing traders and day traders, on the other hand, will care only about price and not about valuation. They are not in a position for the long term, but make their profit by trading with or against flows of money in and out of the market, and often this short term flow leads to market undershoot and overshoot, which in turn creates investment opportunity.