From Greg Wilson, analyst, Palm Beach Research Group: There I was at 8 o’clock in the morning, sitting in a nondescript college classroom on the eastern edge of Nebraska.
The jet-lagged and sleep-deprived crowd shifted and grumbled in their seats. I was worried for the first speaker. The group seemed subdued and unfriendly.
The speaker entered and walked to the lectern. The first thing he said was, “Wherever I go, I want to leave people more uncomfortable than they were when I came in.”
He continued, “I don’t mind if you get pissed off at me. I don’t mind if you don’t like what I say. The one thing I don’t want is for you to be bored.”
That got the room smiling.
Then he said he was going to talk about just two words.
Two words, he said, that are too often used interchangeably by investors—price and value—even though they’re two completely different concepts. This confusion of terms can end up costing folks a lot of money. Tens of thousands of dollars, in fact.
The speaker now had the whole room’s attention.
The $20 Experiment
The classroom was at the University of Nebraska. I was there for the annual Value Investor Conference.
And the first speaker of the day: Aswath Damodaran.
Damodaran knows value. It’s been his calling for the past 30 years as a NYU professor of finance.
He’s written several books on the subject, including the popular The Little Book of Valuation. And he’s had several papers printed in esteemed publications, such as The Journal of Finance.
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Gregory Wilson and Aswath Damodaran at the Value Investor Conference in Omaha, Nebraska. |
Damodaran is also known for his speaking acumen. He’s lectured at some of the top schools and conferences across the country.
The topic he came to discuss that day were the two words I referred to earlier… price and value.
When talking about price and value, Damodaran likes to conduct an experiment. He takes a $20 bill, puts it in an envelope, and then asks attendees how much they would pay for the envelope.
Of course, the collective response ends being up around $20. After all, $20 is $20, right?
But then he adds a twist. He’ll write down a word on a cue card, such as “control” or “brand” or “moat.” Then he’ll put that card in the envelope and ask the same question.
He did this recently at a lecture he gave to a Goldman Sachs Mergers and Acquisitions group.
There, he put $20 in an envelope, but he also added an index card with the word “control” on it. Then he asked the group, "How much would you pay for it?"
One Goldman Sachs executive offered him $24.
To which Damodaran replied, “Sold.”
See, the intrinsic value of the envelope didn’t change—it still held the same amount of money. But by connecting that value with a concept or some other characteristic, like what he wrote on the cards, someone would be willing to pay more or less for it.
Simply put, the value of an asset may be very different from its price. And the drivers for price and value are different as well.
Prices are driven by psychology, momentum, news stories, and such. Supply and demand in the marketplace determine price, and demand is often irrational and human.
Value, on the other hand, is mostly what you’ll find in a company’s ledger. It’s driven by cash flows and the quality and growth of those cash flows. Warren Buffett puts it this way: “Price is what you pay. Value is what you get.”
People often confuse the two. Not only does this make valuation more complicated than it needs to be, it also means investors often spend more on a stock than it’s worth.
How to Make Value Work for You
You wouldn’t pay $100 for a gallon of gasoline. You wouldn’t pay $5,000 for a ham and cheese sandwich. And you wouldn’t pay $250,000 for a beat-up Honda Civic.
You know, generally, when something seems to cost more than it’s worth.
Yet, when it comes to stocks, investors often throw the notion of value out the window.
Some investors get caught up in news stories. They fear missing out on the next big thing. And they end up paying high prices where there is little value.
The way to get around this is to guard yourself with strict buy-up-to prices based on the intrinsic value of a stock.
Let me give you an example of what I mean…
On August 9, 2000, you could have bought shares of Coca-Cola for $30.
Or on April 25, 2008, you could have bought shares of Coca-Cola for $30.
You might be thinking that if you bought at the same price, you’d be getting the same value. But if you bought at one point, you gained 66% after five years, while buying at the other point led to a 21.7% loss.
And understanding the difference between price and value would have let you know which “entry point” was the better investment.
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As you can see, the returns you get are all about the price you pay. Understand the price-versus-value relationship and you’re sure to boost your future returns.
So let me end by simply saying this: If a man named Aswath asks you how much you’d pay for an envelope with $20 in it, say, “No more than $12.”
Because then, you’d be making value work for you.
Reeves’ Note: Did you know about a program we created several years ago called Infinity? It’s a way to get access to our best work and pay a fraction of what you’d pay off the shelf. Infinity gives you details about “off-market” investments you won’t find anywhere else… the kind of private deals Mark and Tom are routinely invited to participate in—and most often do.
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Ask Mark: How to build $1 million as soon as possible…
Today, we continue our special holiday feature “Ask Mark.” In these videos, PBRG founder Mark Ford answers questions sent in by our subscribers. It’s unvarnished and straight from the source.
In todays’ video, Mark is asked what he’d do if he lost his fortune. His answer may shock you…
In case you missed it…
PBRG friend Bill Bonner sent us a special message… He’d like to give our readers “unprecedented access” to his small group of “partners.” New partners can see the specific stocks his family will buy (with $6 million in family trust money)… and learn how to get into them before the Bonner family does…
You can get all the details here (including how to get a “privileges card” that gives you special discounts at the Bonner family’s Pacific Coast hideaway).