We have written a lot of blogs about individual stocks pointing out the difference between price and value (model price). We think it’s time for a more theoretical piece about what we call the rational investor and their relationship between price and value.
In every situation in a commercial transaction, the nexus for decision-making always revolves around a comparison of price and appraisal of value. For example, a rational person is not going to sell a car valued at $20,000 for $10,000. This sort of irrationality does not happen with cars or anything else for that manner. But it happens every day in the stock market.
It’s not easy valuing stocks. Valuation calculations are difficult because businesses are moving targets. While other assets are relatively static, businesses are constantly changing, requiring frequent adjustments to valuation variables.
How do you value a stock?
This is the single most important question that an investor has to answer. The fact that price deviates from value, and sometimes by a wide margin, is welcome by the rational investor. Other investors obsess and worry about price volatility but the rational investor understands that his/her potential profit rises in concert with volatility.
The difference between the annual high and low for the average stock on the New York Stock Exchange usually approximates 50 percent. Businesses do not oscillate in value that much. The average publicly traded business increases in value by about 5-8 percent a year, with the increase being compounded. That means that price change greatly exceeds value change. For the rational investor, at least, that equals opportunity.
The decision-making process focuses on a comparison of price and value.
Before making an investment decision, the rational investor requires answers to two simple questions: “What does it cost?” and “What is it worth?” The first question is easy to answer. Price quotes are now everywhere in today’s society. The second question is difficult to answer, sometimes exceedingly difficult. Regardless, a rational investor will not allocate capital unless both questions can be answered with a reasonable level of confidence.
Price and risk generally move in tandem.
Most investors misunderstand risk as it applies to the stock market. Most do not understand that, generally, as the price declines, risk declines. If the price quote for a stock worth $100 falls from $80 to $60, the risk of buying or owning that stock has declined in concert with price.
Many blind investors will buy a stock because it has been increasing in price. They expect that the upward move will continue. Or they sell because the price has been on a steady decline. They fear the slide will continue. In spite of the fact that price information is sometimes meaningless by itself, investors ascribe predictive power to price.
When irrational investors think about risk, they focus only on price. Price is everything to such investors. The fact that they are not carefully comparing price and value creates an analytical void. Emotions usually fill that void.
Higher prices create enthusiasm and increased interest in buying. Falling prices cause worry, but there is a way for the irrational investor to alleviate the worry…. Sell Everything!
Ironically, irrational investors tend to worry most when they should be worrying the least – when value exceeds price by a wide margin. And they tend to worry least when they should worry the most – when value exceeds price by a narrow margin, or, worse, when prices exceed value.
So there you have it, the rational versus the irrational and price versus value. By constantly calculating “What’s it worth?” Model Price and ModelPriceGuy will keep you on track.