The man who is widely considered to be the father of value investing, Benjamin Graham, once observed that price is what investors pay, while value is what they get.
This statement is just as relevant today as it was when it was first made. Price and value are the two most essential components of successful investing. Any asset will always have a price.
Some investors might be willing to pay the said price. Others may not. Price is a subjective factor.
Meanwhile, the value is relatively fixed. The value of something can be determined by its output.
That's cash flow for companies or rental income for homes. Paying the right price based on the value the asset produces is the hard part. There's no right or wrong price of any asset. However, overpaying can lead to poor returns. Underpaying can lead to higher returns.
This is not a discussion about why value investing is best. Paying the right price for an asset has nothing to do with value investing. Growth investors try and pick companies that look cheap today compared to their future potential. It's the same kind of logic. No one wants to pay an inflated price for an asset and hope someone else is willing to pay more when they want to sell.
That's not investing. That is speculating.
Price vs. value
Warren Buffett (Trades, Portfolio) illustrated the difference between price and value at the 2005 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders.
Buffett was asked what he thought about rapidly rising home prices at the time. He responded with the following story about farmland:
"Twenty-five years ago or so we saw the same thing in farmland in Nebraska and Iowa and surrounding areas...There was a farm about 30 miles north of here that sold for about $2000 an acre in, roughly, 1980. And a few years later, I bought it from the FDIC for $600 an acre.
And you can say, how can you go crazy about farmland? It's going to produce about 45 bushels an acre of soybeans, about 120 bushels an acre of corn. And there's no way you could dream about a tripling, or the internet causing, you know, cornmeals to go up or something of the sort. But people went crazy on it."
That's the distinction between price and value. Just because buyers were willing to pay $2000 an acre for farmland did not mean its value was $2000. Each acre of farmland could only produce so much. The price became utterly disconnected from the value of the asset.
Buffett went on to add that the housing market was a little different because people want to live in their houses. Therefore, they will pay whatever they can to purchase and stay in the home.
However, he did go on to add:
"But when you get prices increasing at far, far greater rates than construction costs or inflationary factors, sometimes there can be some pretty serious consequences."
Sometimes it makes sense for the price of an asset to go up. For example, if the underlying value of the asset is increasing. But prices won't go up forever if the gap between price and value becomes too large. The higher the disconnect becomes, the more buyers and sellers rely on each other to keep pushing the stock higher.
Simple psychology suggests this will not happen indefinitely. Bubbles usually pop because people start asking questions. When everyone rushes for the exit, the price of the asset falls for the same reason it went up in the first place. The crowd wants out.
Sentiment can change incredibly quickly, making it almost impossible to time the market.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Graham and Keynes: Challenge What You Know to Grow
- Seth Klarman: Why Value Investing Works
- Why Is Warren Buffett Interested in Verizon Communications?
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