A question I get very often is, ‘if you could give me the most essential piece of investing advice, what would it be?’ I always give the following answer : Price Is What You Pay, Value Is What You Get
It's a piece of advice that comes from legendary investor Warren Buffett, and serves as a personal guideline for investing.
The Difference Between Price and Value
The essence of Mr. Buffett’s advice is that price and value are not the same thing. Price is something you pay, value is something you receive in return. So when you buy a book, you pay a price for it. It might be $20 for example. But the value you receive from that book can range from absolutely nothing (if you don’t like it) to a life-changing moment (if the book teaches you an important life lesson).
This same principle applies to investing. When you invest in the stock of a company, you pay a price for the stock. This price reflects what the market thinks the company’s stock is worth. However, it could be that the actual value of the company is much higher than investors realize (by the way, we call the actual value of a company the ‘intrinsic value’). When this is the case, we say that a company is undervalued.
The stock market is filled with individuals who know the price of everything, but the value of nothing - Phillip Fisher
You need to know about ''Value Investing''
Investors who are constantly looking to invest in undervalued companies are called ‘Value Investors’. Value investing produced many of the best investors that ever existed, and it is one of the most profitable ways of investing, as you can see in the picture underneath.
What we can see is that those who followed a value investing approach (the ‘Graham adepts’, ‘Buffett adepts’ and a part of the ‘other fundamental investors’) are extremely successful. They outperform the S&P500 by a couple of percentages, some as much as 30%, for long periods of time. That's a very impressive achievement!
''The basic idea behind value investing is investing in a stock that is actually worth more compared to the price it currently trades for''
So one of the reasons the advice ''Price Is What You Pay, Value Is What You Get'' is so important, is because you can earn a lot of money if you are able to identify undervalued companies. However, another reason why it is the most important piece of investing advice, is that failing to understand this concept can result in financial disaster.
For every undervalued company there is an overvalued company..
Way too many investors believe that the price of stock reflects the true value.
This is the number one mistake you can make in investing. It happens very often that the price is much higher than the intrinsic value of a company. This is what we call an overvalued company.
A company can become overvalued quickly when greed and hype kick in. This happens often in times of economic boom, when profits seem to be growing for ever. When this is the case, many investors believe that stocks prices will keep on rising, and are therefore willing to pay a high price for a stock, simply because they believe there is a ‘greater fool’ willing to buy their stocks for an even higher price in the (near) future.
Overvaluation also happens a lot with the most popular and fancy companies.
Imagine coming across a company that has the newest gadget with the flashiest and coolest design. For me, it's hard not to get excited. I realize, however, that on a personal note I can be excited, while the investing part of my brain is cautious. Because it might be that the company is great, and that its newest product will be a success, but this doesn’t mean your investment in will pay off. Because even if you invest in an exceptional company, you are likely to lose money on your investment if you paid too much.
Why would you lose money? Well, the current price of a stock is mostly based on expectations about the future of the company. If investors as a group have expectations that are unrealistic, the company might not be able to meet those expectations. When this is the case, we often see a drop in the share price. This phenomenon is something that psychologists call the ‘Halo Effect’, which is a cognitive bias that exists in the brain of us all (discovered by Edward Thorndike).
The Halo Effect
It turns out that when we see an attractive person, we subconsciously rate this person as better in other walks of life, such as sports, business or intelligence. Even if we have never seen them do any of these things!
The Halo Effect isn’t attached to attractiveness alone but also success. So when we see a successful person, for example the CEO of a company, we unconsciously tend to think this person is successful in other aspects of life as well, even if we have no facts supporting it!.
To relate the Halo Effect to investing : When we think the company’s CEO, products, marketing etc. is good, we also tend to think the investment is good. And this is simply not always the truth.
An Example To Illustrate:
'Disproportionate expectations' is a good way to explain the dot com bubble in the year 2000. A hype was triggered when the internet was introduced to the public. Hundreds of internet based companies were founded, and investors believed these new companies were going to be revolutionary.
The hype was enormous, and a ‘new economy’ was born. Companies no longer needed to be valued according to classic fundamental factors. The one with the highest amount of traffic (website visitors) received millions of dollars in investments.
However, after a while, investors began realizing that these companies weren’t going to produce any meaningful profits. So the bubble burst. If only these investors realized the concept of ‘ Price is what you pay, value is what you get ’ they would have easily seen it coming. Investors paid a lot of money for these stocks, but received almost zero in value.
A graphical representation of the disaster 🙂
Remember: price is what you pay, value is what you get & the price always catches up to the value
So you know it's all about price and value. If you're able to determine the intrinsic value of a company you can compare that with the market price. If the price is lower than the intrinsic value, we can make a nice profit on that investment. That's because the price always catches up with the intrinsic value. At some point the investment opportunity will be recognized by the market. However, determining the intrinsic value is the hardest part to get right. Because two investors can draw a different conclusion when looking at the same fundamental information.
Evaluating a company based on 'price is what you pay, value is what you get'
So whenever you look to invest in a company you need to compare two points:
- What price do I need to pay for its stock?
- What is the intrinsic value that I get?
If the intrinsic value is a lot higher than the listed price, you're looking at a very profitable investment. However is the price is much higher than the intrinsic value, you are probably better off leaving the stock alone. When the mismatch between price and intrinsic value becomes too big, bad things happen. We saw that with the dot-com bubble.
So always think of the advice of Warren Buffett when you are looking to invest in a company. “Price is what you pay, value is what you get.”