Price Is What You Pay, Value Is What You Get.

If you follow Warren Buffett the title of this post might look familiar. It is actually one of his famous quotes and a valuable investing lesson wrapped up into one quick sentence. 

In my previous post about investors dilemmas I talked about how it is nearly impossible to time the market and very difficult to catch something at the “right price”. I also briefly shared that there is a HUGE difference between the price and the value of an investment. In this post, I look to elaborate much more on that.

Let’s do it!

price_value

As a beginner investor you may or may not know that the price (dollar value) you see when you look up the stock price of a company is not necessarily reflective of what the business is really worth or its “intrinsic value”.

Intrinsic Value is simply a fancy word in the finance world that means “real” value. In other words – looking beyond the stock price – what is the REAL value of an investment?Real value is tied to things such as the financial health of the business and the potential that business has to continue growing and being profitable for many years to come.

Think of it as looking beyond what you see  at face value and really digging  “under the hood” of a business to see whether or not purchasing its stock can actually pay off for years to come (or not).

Let’s say you are doing some research on ABC Corporation because you are considering it as a prospective investment. You go to Yahoo! Finance for a quick price check and notice that the dollar value of the stock comes up at $20 per share.

You may think the price is ‘reasonably low’ because you can actually buy a good number of shares considering the money you have available.

What you don’t realize is that, regardless of the price you are seeing, it is possible that the company might be cheap for a reason. Perhaps investors have sold off the stock for one reason or another or the market doesn’t have very high expectations for said investment.  It could also be the case that the company is in a dying industry or in an industry where there is too much competition and they might even be losing market share. These are some of the many scenarios to consider.

It can also be the case that you found a bargain but you won’t know what is the real reason for the “low” price unless you do your homework.

If you don’t do your research and just buy because the investment looks “cheap” you might be adding a loser investment to your portfolio without realizing it. Instead of seeing your money grow overtime you might actually see the stock drop to $15 or $10 per share shortly thereafter.

The fact that the stock seems “cheap” doesn’t mean it will be profitable. 

Repeat this with me:

The fact that the stock seems “cheap” doesn’t mean it will be profitable.

You then look up another company – let’s say one with a per share price of $200 per share. You decide is too expensive based on the price alone, disregard it, and move on to something else. A few years later you decide to take a peek at that same company and see it has more than tripled (true story).

Had you done your homework and did some research to figure out the intrinsic value of that investment you might have concluded that despite the price, the company had potential to be incredibly profitable.

However, many people make decisions to buy something solely based on price which is a terrible strategy to use as an investor.

One method you can use to examine the intrinsic value of a company is through examining its valuation. One of the most commonly used metrics used by investors and analysts alike to examine valuation is the P/E ratio – or Price to Earnings ratio.

Stay tuned for an upcoming post where I will elaborate into this further. This is also one of the several important metrics I teach students in the investing boot-camp.

In the meantime, keep these few tips in mind:

1. Never make a decision to purchase a stock solely because the price seems “cheap”. A cheap price is no guarantee that said investment will be profitable. You have to look under the hood of the business to examine its true potential.

2. Never disregard purchasing a stock simply because it looks “too expensive”. That investment might have the potential to continue ascending (or not). Again, do your homework. *This is where other methods besides P/E ratio might have to be introduced.

3. Ask yourself if the investment you are considering is currently in an industry that is growing and thriving or an industry that is dying and might soon become obsolete. Can it get disrupted by another company? Do you see that business growing and thriving 5, 10, 15+ years from now?

What other questions can you add? Let me know in the comments.

Cheers to profits! $

-Mabel

 

PRICEVALUEBUFFETT

 

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