Perhaps one of the most commonly misused terms by both professionals and laypersons alike is the term “value.” In fact, most what is referred to as “value” is simply a price in disguise. Phrases such as: “The auction value of the painting is $5,000” [Antiques Roadshow]; “These are the top four things that determine a house’s value” [Investopedia]; or “By this measure, stocks are massively overvalued” [CNBC] are just but a few examples of how widespread the confusion between value and price seems to be. And things can get even more confusing when the term “market value” is used.
Price and value are fundamental building blocks in a market economy. Understanding their function and relationship dynamics provides both, the context to make informed decisions about transactions, and a strong foundation for building wealth.
The Essence of Value and Its Application – At its core, “value” can be defined as how much a future benefit is worth today. Note that this assessment is highly dependent on the needs and expectations of the person doing the evaluation. Also, it incorporates two adjustments. The first compensates for the delay involved in obtaining the benefit later rather than today. The second adjusts for the likelihood of receiving a benefit that could be different from what it was expected. In financial terms, the future benefits take the form of cash flows and the adjustments are encapsulated in a rate of return which includes two components: an adjustment for the time value of money in the form of a risk-free rate and a premium adjusting for the potential variability associated with the cash flows (aka, risk).
In a free and open market, buyers and sellers will determine independently how much an item is worth and then engage in a negotiation to reach an agreement. The amount that settles the negotiation becomes the item’s market price. Two factors in this process provide important insights. First, each value assessment depends on the assumptions made by each market participant regarding the future benefit and its corresponding risk. Second, price is the result of a negotiated process that is often influenced by the forces of supply and demand, market momentum, the type of buyer/seller, and the negotiating ability of the parties involved.
The considerations in this process provide the framework that highlights the distinct nature of price and value and their relationship dynamics. To consider an item overpriced or underpriced, one must rely on the context provided by the item’s value.
Also, it is important to note that future benefits associated with the creation of value can take many forms. This could involve a solution to a pressing problem, the satisfaction of a customer need, or in the case of financial assets, cash flows. Note that currencies, commodities, and collectibles do not generate cash flows and thus cannot be valued. They only can be priced by exposing them to the dynamics of a market.
Investing vs. Trading – Understanding the fundamental difference between price and value also provides important insights about the behavior of financial markets and the process of wealth creation.
When we buy a financial asset, it is critically important to be clear about the reasons for the purchase. And the key question to ask ourselves is this: Are we trading or investing?
If the answer is that we are trading, then we need to familiarize ourselves with the behavior of prices in the marketplace. Factors such as price volatility, current trend, support and resistance levels, trading volume as well as market mood and momentum are some of the factors we need to consider. Good money can be made, if three conditions are met: (a) we follow an established or emergent market trend, (b) we adhere to a sound money management plan to cut losses and harvest profits, and (c) we sell at a price more favorable than the one we paid. Of course, there are myriad other considerations at play that make the process of trading much more complicated than just described. But the key point to keep in mind is that trading is about understanding and exploiting price behavior.
An example of this process is momentum trading. It consists of a day-trading strategy that looks to profit from high-volume moves in a stock’s price caused by market overreactions to information. This type of trading happens very fast and good timing and strong money management skills are critical. This probably explains why less than 1% of traders are consistently profitable.
On the other hand, if the answer is that we are investing, then we need to determine the asset’s value and identify its current price and trend. This will allow us to determine whether the asset is fairly priced and thus help us decide if it is a good investment opportunity. Keep in mind that the determination of value involves many assumptions about the future benefits and their associated risk. As such, it is rare that value estimates developed by different people will be the same. The use of a “margin of safety” advocated by Ben Graham, who is considered the “father of value investing,” is a practice that recognizes that estimates of value depend greatly on the accuracy and reasonableness of the assumptions made. As a result, one should only purchase an asset or security when the current market price is significantly below its estimated value.
Value investing is a popular strategy where stocks are selected based on the current discrepancy between the price at which the stock currently trades and its intrinsic value. In order words, value investors actively seek stocks they believe are underpriced and will hold them until the market recognizes its value and adjusts the price accordingly. This is the investment style favored by legendary investors such as Warren Buffet, Seth Klarman, and Walter Schloss.
The Myths of Value – Another important consideration about the concept of value is that there several misconceptions that can easily create ambiguity and lead to the wrong conclusion. Specifically, there are three widely accepted truisms to examine:
Value is Unique. Although most people refer to “value” as something distinctive, an asset can have several values at once – all depends on the context. For instance, in the professional realm of business valuation, there are several different “standards” of value, such as fair market value, fair value, investment value, intrinsic value, and liquidation value, among others. Each one of these definitions is governed by a different set of rules and their use depends on the intended purpose of the valuation. Consequently, an asset can have several different values, each one related to a particular situation or application.
Value is Consistent. Value is a forward-looking concept driven by assumptions which make it dependent on the person (or entity) performing the assessment. People tend to have different expectations about the future based on their experience, plans, and hopes. Also, their risk tolerance tends to be different depending on their circumstances and past experiences. As a result, two people presented with the same facts are likely to reach different conclusions about an item’s value, thus validating the phrase, “value is in the eye of the beholder.”
Value is Constant. Most people think of value as having enduring qualities that are not expected to change in the foreseeable future. However, value will change any time its original narrative is impacted by events that are likely to influence the future benefits and/or their risk. In addition, the impact of these events is likely to be assessed differently depending on the resources and prior experiences of those doing the evaluation. In turn, even when there is agreement that the original narrative has changed, the extent of the adjustment is likely to be different. Therefore, to understand value one must be clear about its narrative and understand how events are likely to affect it.
Being Clear on the Fundamentals – Although the term “value” is often taken for granted, understanding its drivers and its relationship to price can be very useful and can lead to successful transactions and wealth building. Unfortunately, value is not a straight-forward concept with a single and unequivocal definition. Hence, mastering its application requires clarity in defining the underlying assumptions, being attentive to changes in the narrative and their effect on the original assumptions, and knowing how to take advantage of value-price discrepancies.
In the end, it is always helpful to keep in mind a phrase by the famed investor Warren Buffet: “Price is what you pay. Value is what you get.”
About the Author
Enrique C. Brito, MBA, CFA, CVA, CM&AA is a managing director of Kaizen Consulting Group, a strategy and M&A advisory firm headquartered in Richmond, VA providing business strategy, M&A and capital formation advisory services. He has 20+ years of corporate finance and investment banking experience and lectures nationally on the subjects of M&A, business valuation, and negotiation.
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