Stock Price does not equal Value

Valuation may be art not science, but it approximates the truth. It helps an investor understand how much a price is lying.
By Larissa Fernand |  29-09-22 | 
 

Price does not equate value.

Hugh Selby-Smith, the co-Chief Investment Officer of Talaria Capital, explains why in a very simple way. Here are some pointers from his article in Firstlinks.

Price is a liar.

Price is a liar is a bold proposition. Many might argue that it is also absurd. But understanding price is vital to understanding financial markets and it needs careful consideration.

Price pretends to be an objective measure, a metric as reliable as a centimetre, a kilogram and a second. But price is a liar because it has no link to the material world, the world of hard facts. It is no more accurate than a handshake. It is less a measure than an event.

Scientists define the kilogram based on physical constants. Its characteristics are precise regardless of time or place. A kilogram in Melbourne is no different to a kilogram in London or New York. A 2019 kilogram was not heavier than a kilogram today nor will it be heavier than a kilogram in 2025.

Price, on the other hand, has no scientific or mathematical definition. It is no more than when buyer meets seller, demand meets supply, and opinion meets money. People drive prices, and people, as behavioural economists like Tversky, Kahneman and Thaler have shown, are not rational.

Quick Take: Why the buy price of a stock matters

Valuation is a defence against behavioural biases.

Valuation may be art not science, but it approximates the truth. It helps an investor understand how much a price is lying, both for good as well as ill. After all, prices can be too low as well as too high.

Valuation’s premise that an asset is worth the sum of its future cash flows still leaves plenty of room for blow-ups, after all that word ‘future’ is a minefield. But it also allows for a structured, repeatable process based on something resembling objectivity.

Terms that appear often in the stories of people trying to sell you something mean no more to valuation than the cash flows the words represent. Wonderful companies, beautiful cashflows, disruption, growth, moats, and the rest only matter to valuation as numbers. 

Quick Take: A cheap stock can be an expensive mistake

Investing with reference to valuation is not the same as value investing.

Value investing aims to work out an asset’s worth and then buy it at a discount. A value investor might only transact if they can buy a dollar for 80 cents, expecting that the price will move up to what is known as intrinsic value over time.

Another sort of investor might buy something at fair value or a premium because, having identified where they stand in relation to an asset’s value, they have reasons other than money to motivate them.

We have all bought or sold something at what is known in markets as the ‘wrong price’ out of clear-eyed choice, “I really wanted that house, car, ring etc even if I am over-paying”. This is a different sort of falling for it.

Related Reading: What to be aware of when valuing younger companies

When stock prices sink, the temptation may be to dive in. Keep this is mind before you do so:

1) Try to identify opportunities that do not rely on, let alone magnify, the market’s direction. Look for what are called low beta equities.

2) Favour shares with shorter rather than longer payback periods. This may be no more than saying favour good value.

3) Hunt down income, especially in conjunction with my first and second suggestions. Income has been the poor relation over the last decade or more but anyone with an eye to history understands its integral role as a component of total return.

The above is an excerpt from an article that originally appeared in FirstLinks titled Price is a liar: take three steps before you dive in

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