Why Price and Value Are So Important
It’s important to understand price and value.
As Warren Buffett says, “Price is what you pay. Value is what you get.”
But what does that even mean? Well, it means that the price you pay and the value you get are not always the same.
As I’ve explained before, the price you pay for an asset is the most important thing when it comes to being a successful investor.
Generally, buying assets at cheap prices equals an investor making money. Buying assets at expensive prices equals an investor losing money.
Another one of my favorite quotes is from “Super Investor” Walter Schloss. Like Warren Buffett, he was also a disciple of Benjamin Graham. (Benjamin Graham is known as the father of investment analysis.)
Schloss says, “Price is the most important factor to use in relation to value.”
A common way to understand price and value is by using the price-to-earnings ratio or P/E ratio. It’s a good starting point for finding bargains.
The P/E ratio is the price an investor pays for $1 of a company’s earnings or profit. Another common way to describe the P/E ratio is that it shows how long it will take for the investor to earn their money back.
Let’s look at an example… A fake company called ABC Hats.
The stock is currently trading at $87. It’s earnings per share (or EPS) over the last four quarters or (TTM – trailing twelve months) is $3.
Which means it’s P/E ratio is 29. (P/E calculation is the stock price divided by EPS.)
This means investors are willing to pay $29 for $1 of earnings. Another way to look at this is that at this price, it would take 29 years for the investor to earn back their money. (If the company earned $1 every year.)
Now, let’s say its average P/E ratio over the past ten years is 15. That means on average, investors have been willing to pay $15 for $1 of earnings.
Then we find that in the last market crash or at the bottom of the market during the global financial crisis its P/E ratio went as low as 10. Meaning investors were willing to pay $10 for $1 of earnings.
Which sounds better? Buying at a P/E of 29, 15 or 10?
Of course, buying at a P/E of 10 or 15 means the investor would get much more value for the price they pay. For example, an investor who bought at 15 and sold at 29 made almost 100%. An investor who bought at 29 and sold at 15 lost half their money.
This basic analysis gives us a range of values to help understand the price we might be willing to pay to own a share of ABC Hats. It also helps us understand the value we would receive at a given price.
In this example, a P/E of 29 seems too expensive. Even if you buy the best business in the world at an expensive price, there’s a good chance you will lose money. At the very least, it would take years to earn your money back.
The investor who understands price and value may look to buy when the price comes down to a P/E range of 10-15. Now, that could take months or years.
At this point, the investor might put it on his watch list and look for another investment opportunity. There’s always opportunity somewhere. The investor just needs to be patient.
Word of caution… This is a basic example so you can see how the process of finding value works. Just because a company has a low P/E ratio compared to its historic average doesn’t mean it’s a good buy.
A high P/E doesn’t always mean the company is a bad buy either. Maybe the company is growing fast. If so, investors are willing to pay higher prices for that growth. (A good way to buy these kind of companies is during a market correction or on bad news that is only temporary in nature. It’s hard to find fast growing companies or great businesses at cheap prices. These opportunities only come a few times a decade.)
Different industries have different ranges too. You can’t compare the prices of companies selling jet engines to selling business software. The nature of these businesses and growth opportunities are just too different.
Also, an investor should make sure the company is in strong financial health. Meaning that it’s not carrying too much debt where bankruptcy could be in the future.
An investor should also make sure the company’s earnings have been consistent if not growing over the past several years. In other words, the company should be growing sales and have a product or service that is in demand.
After looking at the P/E ratio, it’s helpful to look at the stock price.
An easy way to do this is to get on a financial website like Yahoo! Finance and type in the ticker symbol for the company you’re interested in.
Once you type in the ticker symbol you can click on the chart. From there, you can look at the price over a three, five or ten-year period.
A ten-year price history is a good start because it usually accounts for at least one bear market or major stock market correction.
This provides a good snapshot of its fluctuations in good times and bad times. In other words, its high and low price over the given timeframe.
Again, I’ll use another quote from Walter Schloss.
He said, “When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as $125 and then decline to $60 and you think it’s attractive. Three years before the stock sold at $20 which shows that there is some vulnerability to it.”
Of course, you need more than just a glance at a ten-year stock chart before you decide to buy a stock. But this is another great way to know whether the stock is at all-time highs or near all-time lows.
It’s also a great way to see what the “herd” thinks of the stock. Always remember, a successful investor ignores the herd. Better yet, the successful investor sells to the herd.
In summary, analyzing the P/E ratio and price history are two simple yet powerful ways for an investor to find value.
The reason finding value is so important is because if you consistently buy great assets cheap, it will create huge positive effects on your wealth.
Consider using these two tools the next time you’re researching stocks to buy. You’ll be well on your way to understanding price and value.