Lesson 7 – Price and Value, Margin of Safety

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Lesson 7 – Price and value, Margin of safety

Today is the day we finally talk about stock prices. In the earlier lessons we have talked about topics related to understanding the business.  Now we come closer to the stock market in this lesson.

The difference between price and value

Most beginners to the stock market are interested in knowing stock prices.

  • What is ITC trading at today?
  • How much has Infosys gained over the last week?

If you are investing for the long-term, after reading this lesson, you will ask different questions like,

  • What is the intrinsic value of Infosys?
  • Is Tata Motors richly valued?
  • Does BHEL, the power equipment maker,  look undervalued?

It is a big shift in the way you think. Let me give you an analogy.

As of March 2013, a Tata Nano car costs around Rs. 1.5 lakh. Suppose I represent the manufacturer, Tata Motors.

What if try to sell you the same car at Rs. 5 lakh?

Would you buy the car?

No!

Why?

In our car example, the value is Rs. 1.5 lakh (or even lesser or more based on your perception) and the price that I ask you to pay is Rs. 5 lakh. It clearly seems overvalued.

Many participants in the stock market skip this check when they buy a stock. They simply don’t know the business they are buying at a particular price. They only look at the price.

Every business has a certain value.  There can be a difference between price and value. In fact the stock market will provide you many examples of stocks with wide differences between price and value.

As Warren Buffett, one of the gurus of investing said,

Price is what you pay. Value is what you get.

These are very simple but deep words. I sincerely request you to remember them for life.

 

Overvaluation and undervaluation

Consider a used car lot where there are a wide range of cars on sale at different prices.

Some of them are relatively light cars in terms of performance, mileage and safety. Yet they carry a heavy price tag. You need to be rational and walk away from such deals if the price seems unreasonable.

Some of the cars have turbocharged engines and superb power. But their body is dented or it needs a paint job. They are selling for 50% of the price of similar cars with a great exterior. One needs to check whether the exterior can be done up without too much cost. If yes, it might be a bargain. Such deals are worth exploring and can give you great returns.

Compare this with what the stock market offers you.

There can be stocks which are overvalued. The market price is higher than the value present in the company.

Some might be undervalued stocks. The market price is lower than the value present in the company.

There is greater chance of making good returns in undervalued stocks than overvalued stocks. It is common sense.

But for that you need to be in a position where you can understand the value in a company.

How can I find the value in a stock?

In science there are fundamental axioms which do not change.

For example, g is the acceleration due to gravity at the Earth’s surface. g has a value of 9.8 metre per second squared. The value of g is constant.

Investing is not science. Investing is more of an art. It cannot be distilled into firm rules and axioms like science. There are human emotions of greed and fear at play which don’t follow science or rationality.

Value is subjective.

There are multiple ways to calculate the value of a stock. You will be learning the different techniques of valuing a stock in subsequent lessons.

In the interim, have a look at this example.

When we try to calculate value, you and I might start with different assumptions for a particular company. For example, I feel that the growth rate of the company for the next 5 years will be at least 15% per year. You might have a better insight into the company’s business as compared to me and feel that it will grow by 20% a year.

Who is right? Who is wrong?

Those are the wrong questions to ask. These are our views.  We don’t know what the future holds.

Maybe in the future, both of us are proved wrong when the company goes bankrupt. It is possible.

For now, I want you to understand that our views and assumptions about the business behind a stock are used in different techniques. These techniques lead us to the value in a stock.

 

Margin of safety

There are factors which no one can predict or foresee accurately. For example, the economy, competition, a drought, or globalization that affects a business.

There are factors which are in the realm of human understanding. Especially, historical data about a company. But, to err is human. We can miss or misinterpret past data that we should have understood clearly.

With either known factors which we do not capture in our valuation process or unknown factors, understanding of value today can be proven wrong tomorrow with adverse developments.

Hence, in stock investing we try to check whether there is a margin of safety.  Benjamin Graham, who taught Warren Buffett, is known as the father of the value investing philosophy. Benjamin Graham advocated buying a stock (or for that matter any instrument) when there was a margin of safety in the investment operation.

How?

The market price needs to be sufficiently lower than the value.

There is usually higher risk with an overvalued stock. Sometimes, the market bids up the price of a stock to a level higher than the embedded value. The price may stay high for a long period of time. Sometimes, even for a few years.

Sometimes, for no obvious reason. The market can be irrational.

Sometimes, overvaluation can occur with excellent business with great prospects. You can make money if you ride the rising wave.

But in such cases, if a stock is richly valued or overvalued, one bad quarter of results or a business setback which is unforeseen may cause the stock to crash down badly. It is possible to go wrong even with the best blue-chip stocks.

Please start taking the margin of safety principle very seriously. Buying into a stock with a margin of safety does not guarantee zero losses. It would be wrong for me to say that.

What I can say, is that on average, it will protect you. Avoiding big losses is half the battle won when you are starting your stock investing journey.

 

Have I missed something?

In all this I have not explained how we find out “value”. That is the next topic. And it is very interesting because there are multiple ways to calculate or ascribe value to a stock.  Value like beauty is in the eyes of the beholder!

Till next time…

P.S. I have nothing against Tata Motors and Nano.

 

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