Price vs. Value

Why this matters

Part 3 was about whether STU Corp is a good business. This module asks a different question: is $50 a sensible price for a share of it? A wonderful business can be a poor investment if you pay too much, and an ordinary one can be a good investment at a low enough price. Telling the two apart starts with separating price from value.

Two different things

In his 2008 letter to shareholders, Warren Buffett passed on a line from his teacher, Benjamin Graham: "Price is what you pay; value is what you get."¹

• Price is a fact. It's what buyers and sellers agree on right now, and it's on every screen.
• Value is an estimate. The intrinsic value of a business is what it's worth to an owner, based on the cash it can produce over its life, adjusted for when that cash arrives and how uncertain it is. Nobody can look it up. The last module of this part shows how to estimate it.

Prices swing; values move slowly

In his 1987 letter, Buffett described Graham's way of thinking about market prices: imagine a business partner, Mr. Market, who offers every day to buy your share of the business or sell you his. His prices swing with his moods: very high when he's euphoric and sees only good news, very low when he's gloomy and sees only trouble, even though the business itself is steady.² You don't have to trade with him. You can simply take advantage of his prices when they're far from what the business is worth.

Suppose STU Corp's business barely changed over a year, while its share price did this. The prices are hypothetical.

Moment	Share price	Mood
Start of year	$47	Calm
After a market-wide sell-off	$38	Gloomy
After a viral post about water quality	$62	Euphoric
End of year	$50	Calm again

The highest price was 63% above the lowest, yet the business, its customers, and its profits changed far less. If you had a sound estimate of STU Corp's value, those swings were opportunities, not threats.

Value is a range, and the market is a crowd

Because value depends on the future, any honest estimate is a range, not a single number. Different reasonable assumptions about growth, margins, and risk give different answers. The market price, meanwhile, is the combined judgment of a huge number of buyers and sellers, many of them well informed. That's a high bar to beat, and it's why Index Funds is a sound approach for many investors. To believe a price is wrong, you need a specific reason: something the market is overreacting to, or overlooking, that your research can point to.

Key takeaways

• Price is what you pay; value is what you get.
• Intrinsic value is what a business is worth to an owner, based on the cash it can produce, adjusted for time and risk.
• Prices swing with the market's mood; values change slowly. You don't have to trade on Mr. Market's quotes.
• Value is an estimated range, and the market price is a crowd's estimate. Disagreeing takes a specific reason.

Check your understanding

A company's share price falls 25% in a week when the whole market drops, though nothing about its business has changed. What's the most reasonable view?

1. The business must now be worth 25% less.
2. The price drop proves something is wrong that you haven't found yet.
3. The price moved with the market's mood. Its value may have changed far less.

Why should an estimate of intrinsic value be a range rather than one exact number?

1. Because ranges are easier to calculate, and a single number would need far more data than investors have.
2. Because value depends on future cash flows, and reasonable assumptions about the future differ.
3. Because the share price changes every day, so the value has to change along with it.

What's next

Before comparing price with value, you need to know what the price is buying. The next lesson, Market Cap vs. Enterprise Value, shows why a company's debt and cash change the picture.