How do we compare the price vs. value of an asset?
When buying a car, do you always pay the retail “sticker price” that is quoted? Or do you look online to see what the real value of the car is—what people are actually paying to take that car off the lot?
The reality is, almost nobody is paying the full “sticker price” vs. the value of a brand new car—because they know that’s not what it’s really worth, and they know how to get the information they need to determine the fair value. They know they can get it for less when all is said and done through negotiation or other deals—even though that’s the price quoted from the dealer.
The Price Doesn’t Always Equal the Value in Your Investments Either
Investing is probably the area where price vs. value is most commonly misused. Many investors and traders confuse the meaning of value when they talk about the price of an investment. They use the words interchangeably.
For example, someone might say, “Apple stock has a value today of $95.04,” simply because the stock is trading for that price on the New York Stock Exchange. However, investors need to understand that just because that is the cost to buy Apple on July 10, 2014, it has absolutely nothing to do with the value. As Warren Buffett says, “price is what you pay, value is what you get.” Price vs. value must always be considered to determine the suitability of any investment.
Then How Do We Determine the Value of an Investment?
There are many different ways to calculate the value of an income producing asset. However, most of the methods involve determining the future cumulative cash flows and then discounting that back to the present value in today’s dollars. This sounds complicated—and it was back when I was first learning business mathematics and having to manually calculate by using present value and present value of annuity due tables. However thanks to the computer and now having the tools available online, these calculations are really pretty simple.
The important concept to understand is that an investment’s value today is determined by looking at the amount we think it will sell for at a later date combined with the income we can accumulate during the holding period of the asset discounted back to today.
Whoa, does this sound complicated? Let’s break it down and look at an example:
We will assume we can purchase a single share of Apple stock today at $95.04. (The quoted price at market close.) This is the price of the asset, or stock.
This means that that the value we place on this stock today is $67.93. The current price might be $95.04, but the value to us is only $67.93.
In order to invest in this stock, we will need to patiently wait for the cost to fall to the value we’ve placed on it. Of course, if much time goes by, then we will need to recalculate the value based on up-to-date figures at that time, including new earnings, dividends, and company news—among other components.
Only Buy on Sale—When Price vs. Value is Favorable for You
It’s important to keep in mind when investing in any asset that you want the price you pay to be less than or equal to the value you receive. Therefore, you can use this same process when calculating the value of any asset you are considering for purchase. This applies to stock investments, business, real estate, or anything else you can place a value on.
The price quoted on the front sticker of a new car almost never equals the value. The same can be said of stocks and other investments. Use this mindset and calculation the next time you are contemplating a purchase. It is simple, efficient and accurate—and can be repeated over and over again. It will get you some fantastic deals—not just when shopping—but when you are making investments as well.
Remember, the market price doesn’t necessarily mean that’s what its value is. Always compare price vs. value: price is what you pay, value is what it’s really worth.
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