Principles of Valuation Part 2: Price Is What You Pay, Value Is What You Get
“Price Is What You Pay. Value Is What You Get.”
The venerable investor Warren Buffett has a real knack of putting complex concepts and ideas into simple and easily understood terms. In my opinion, his quote, “Price is what you pay. Value is what you get” is one of the more profound and important statements he has ever uttered. If truly understood, these simple words represent perhaps some of the most important bits of investment wisdom that an investor could ever receive. Therefore, stated succinctly, the answer to the question when to buy is simply when you are reasonably certain that the company’s stock can be purchased at a sound valuation.
This concept of value represents the key to receiving the full benefit that these wise words provide. Knowing the specific price that you paid is simple and straightforward. And, although many have an intuitive understanding of value, its deeper meaning is often only vaguely comprehended. Anyone who has truly made the effort to study Warren Buffett’s investment philosophy understands that receiving value on the money he invests is of high importance to him.
So how do you know, when buying a stock, if you’re getting value or not for your money? I contend that the answer lies in the amount of cash flow (earnings) that the business you purchase is currently generating on your behalf. And regardless of how much cash flow the business is generating for you, its value to you will be greatly impacted by the price you pay to obtain it. If you pay too much you get very little value, but if you pay too little then the value you receive is greatly increased.
Therefore, if value is what you’re looking for, then it’s important that your attention be placed on the current cash flows that the business is producing. Unfortunately, few investors possess the presence of mind to focus on this critical element. Instead, investor attention is more commonly and intensely placed on stock price and its movement. A rising stock price is usually considered to be good, and a falling stock price considered bad.
Another investing great offered his view on this important point: “Just because you buy a stock and it goes up does not mean you are right. Just because you buy a stock and it goes down does not mean you are wrong.” Peter Lynch ‘One Up On Wall Street’
Just like the Warren Buffett quote that this article is based on, Peter Lynch’s quote is also based on the principle of sound valuation. The point is that a rising stock may be dangerously overvalued, while the falling stock price may indicate that the company is becoming a rare opportunity on sale.
Knowing the difference will materially impact not only the long-term rate of return the investor receives, but perhaps more importantly, the risk they take to get it. As I will illustrate later in Part 3 of this series, you can dramatically overpay for even the best company. Because, it is a truism, that the stock market can and will grossly misappraise a security from time to time – over or under.