Friday, May 25, 2018

All About Price: Introduction & Valuation of Value

In our everyday lives, there is one attribute that you will see, hear, use, ponder and gawk about most of the time. Yes, that attribute is price. Whether you are comparing on the same item across different places, different items in the same place, or different items across different places, the notion of price will always be there.

Zooming into the financial markets, the price of the financial instruments will be the first thing you will encounter; the bid/ask figures on your trading platform, the ticker tape shown on most business news channels, etc. There is no way you could invest or trade without ever looking at the price first.

Throughout this intermittent series about price, we shall look into its concept and context, and how it affects us in the world of investing and trading in terms of perceptions, decisions and results.

First up we will talk about the valuation of value.

Price vs. Value

“Price is what you pay. Value is what you get.” – Warren Buffett, 2008 Letter to Berkshire Hathaway shareholders.

This saying made by the ‘Oracle of Omaha’ is often quoted in most investing communities, particularly value investors. In gist, the share price of a company does not necessarily reflect its underlying value. Price and value will fluctuate over time, and along the way the price will go above, below or remain the same with the corresponding value. Value investors would love to get their company shares when the price goes below the value, as they are viewed as a discount, ceteris paribus.

Valuation Methods

The intrinsic value is considered to be the widely accepted value of a company in most investment literature, and it is calculated using the discounted cash flow (DCF) method (read up from Investopedia here). However, others use a variety of valuation parameters, such as book value or net asset value (NAV), net current asset value (NCAV) (read up from Investopedia here), etc. Furthermore, the investors may use one, some or all of the valuation methods to come out with their own aggregated value.

So what does this mean? We would have a whole range of values popping up by different value investors using various valuation methods on the same company at a given point of time. In other words, a company could have many values, depending on how it was looked at.

For example, Company A’s current share price is at $1.00. Investor X valued the company at $1.20, so Company A is viewed as a bargain. On the other hand, Investor Y used another valuation method and felt that Company A is worth only $0.80, thus Company A is expensive.

And The Point Is?

While the quote by Buffett holds true, value is still subjective depending on how the investors arrive at their numbers. The myriad of price points generated by this range of derived values, coupled with other participants that do not use any valuation method at all, partially provides the liquidity of the buying and selling in the financial markets.

On another note, in my ebook, I used NAV and Price-to-Earnings (P/E) ratio valuation as part of my selection criteria, but you could also use other methods as you deem fit. Valuation is just one part of fundamental analysis, and there are other criteria and requirements to think about when selecting what to buy or sell.

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