Understanding the difference between price and intrinsic value
can make a big difference in your investment principles. We have seen
these key words interchange that now in the investing world it gets
blurred much too often. Everyday investors that don't trully know the difference convince themselves that they do and then they make an investing decision on an ultimately flawed understanding.
Price is a relative value
like if you use Price to Earnings Ratio (PE), this is a relative value.
Take an example the housing market. What a house or a condo sells for
is basically based on what the market dictates the price be
and this usually depends on the most recent transacted value. Are you
actually valuing the entire house? How much each brick is worth? How
much the land is actually worth? How much your location is worth? Nope,
you are not. That is price, what the MARKET deems it is worth now. So if
you use PE, you are not really paying for the intrinsic value, you are
paying a 5X, 10X, 15X what the market price is.
Intrinsic
value is where you actually analyze what a company is actually worth.
You can calculate the assets they have or you can discount the companies
current or future cash-flow, but what you are trying to do is pay less
than what it is actually WORTH, not paying less than what the MARKET is pricing it.
Its
a much simpler way to understand the difference between the two and
this makes a huge difference in your investing because a company that
has a PE of 100 can be "cheap" compared to a company with a PE of 5
which could be extremely "expensive" if you are buying based on its
intrinsic value.
So the next question naturally is - which one to actually use?
Well, both if possible. Just use them correctly.
You
can use a relative value like PE to filter a stock that is trading less
than what its peers are trading at. So you get a security that is lower than the market price. You can then calculate its intrinsic valuation to determine if it is actually "cheap" and then make an investment.
There
is many more misrepresentations out there and we will slowly cover them
one by one. But the next time you pick up a analyst report, read an
article or listen to any advice - when you see that the information
can't even determine correctly between relative and intrinsic value, its
up to you to then get that right.
Else you can only blame one person if you overpay for a stock - and that is you.
https://www.laburlah.com/single-post/2017/04/04/Price-versus-Intrinsic-Value---There-is-a-difference
