Value is what something is worth and price is what something costs

By Bob Peters || October 27, 2021

Financial Security is achieved through Behavior that allows you to Invest Wisely over many years.  Necessary Behavior is to Invest Wisely and to know the difference between Investing vs. Speculating.

“Value vs. Price” is another very important concept.  Value is what something is worth and Price is what something costs.  Sometimes these overlap but many times they do not.  If you do not, or cannot, determine the intrinsic value of an asset you are speculating.  Assets that do not have intrinsic value are speculative.  Many people look at the Price of a stock and trick themselves into believing that is reflects its Value.  Price is not Value.  I shared two of my personal mistakes in an earlier post.  In one of those examples I lost all of my money speculating when I thought I was investing.

Let’s start with Cash (the paper or electronic version)

Let’s start with cash (the paper or the electronic version).  Everyone needs cash to pay for Basic Needs and Wants.  When you prepare your Budget, you are allocating the cash that you earn from your job towards your Basic Needs. You also save for medium/long term expenditures, building up emergency reserves and Investing Wisely towards your Financial Security. 

Both Speculating and Investing Wisely require you to use cash.  You might Invest Wisely for 18 years to pay for your childs’ college or trade school education.  When he/she goes to college/trade school, you would convert these investments into cash.  Speculation also requires cash upfront with the “hope” that you convert the speculative asset into more than the upfront cash.  Investing and Speculating start with cash used to purchase assets and end by converting the assets back to cash.  It’s easy to confuse the two.

Businesses that generate cash flow have Intrinsic Value

Businesses that generate cash flow have Intrinsic Value.  Google is a very profitable business with Intrinsic Value that is wholly owned by a company called Alphabet, Inc.  In 2020, Alphabet reported profits of $40.2 billion with approximately 637,067,053 shares outstanding.  If you owned one share of Alphabet, your share of the 2020 profit would be $58.61.  On December 31, 2020 of one share of Alphabet closed at $1,751.88 or 29.9 times the most recent years’ profit.

Said another way, it would take 29.9 years of profits to cover the cost of the $1,751.88 stock price as of 12/31/20.  We know the price of one share of Alphabet.  In addition, we have one other piece of information. We know the number of years of current profits required to cover the initial cost of one share.

Now let’s look at two other dates; December 31, 2017 and September 30, 2019.  The price of one share of Alphabet on 12/31/17 and 9/30/19 was $1,046.40 and $1,081.91, respectively.  If we look at price alone we would say December 31, 2017 was time to buy the share because it was the lowest price of the three dates.

Value is relative

Value is relative.  Using the same methodology as we used to determine that it would take 29.9 years to recover the 12/31/20 share price it would take 51.8 years and 21.2 years based on the share price on 12/31/17 and 9/30/19, respectively.  We have now introduced a concept of relative value.  One date is relative to another.  In this example the number of years it would take in profits to earn back the price of the share as of three dates. 

Value is relative.  On the surface, the lowest share price on 12/31/17 looks like it would be the best of the three dates to purchase a share of Alphabet.  However, when we start to look at the number of years to recover the respective theoretical purchase price it seems much more attractive to have bought a share when it would have only taken 21.2 years, not 51.8 years.  There are many other aspects of determining value but it’s a good step to just think about this relative value concept.  

The more years it takes to cover the cost of purchasing shares the greater the chance the business will falter which means “higher risk”

Just looking at the number of years of current profits it would take to cover the purchase of one share (also known as the “Trailing Price to Earnings ratio”) is NOT an intrinsic value analysis but it is better than looking at price alone.  The more years it takes to cover the cost of purchasing shares the greater the chance that the business will falter which means “higher risk.”  In reality, future profits and the number of shares will not stay the same.

An intrinsic value analysis is applying judgement to the probabilities of the business’ future cash flow.  Considerations include competition, profit margins, disruptive technologies, regulatory risks, growth opportunities, etc.  Warren Buffet provides an explanation of Intrinsic Value to a class at the University of Georgia.  It’s worth less than 6 minutes of your time to watch this one.

One (almost) last point

One last point:  The reason why I feel so strongly that Investing Wisely is achieved through buying low cost, index exchange traded funds which own many businesses is because it takes a lot of time, fields of study in accounting and finance and rigorous industry analysis to perform an intrinsic value analysis.  This analysis is not a “one and done”.  It needs to be refreshed constantly as new information that would impact the business’ future cash flows come to light.  An intrinsic value analysis is time consuming and we know that 80% of all professionals that try to pick stocks to outperform the market actually underperform.  If you choose to purchase individual stocks and have studied accounting/finance and are inclined to maintain the rigor of doing intrinsic value analysis then please go ahead.  But if you purchase individual stocks and do not perform and maintain this level of analysis, then call it what it is:  Speculating.

Assets that do not generate cash flow do not have Intrinsic Value

Assets that do not generate cash flow do not have Intrinsic Value but they can be used for enjoyment or utility (like a personal computer, snowboard, backpack, tent, bike or electronic tablet.)  You use them until they are no longer functional.  These are depreciating assets and they contribute to our quality of life. 

Some people purchase assets (i.e. Collectibles) that do not generate cash flow but they satisfy a passion.  Collectibles range from comic books, sports cards, jewelry, antiques, sneakers, wine, etc. As with any asset that does not generate cash flow, until the time that you sell it to someone else, these have no intrinsic value.  My strong advice:  Do not purchase collectibles as part of your Investing Wisely plan to achieve Financial Security.  The long term rate of return on collectibles is much lower than for shares of businesses.  Purchase non cash flow generating assets if they give you personal pleasure and you can afford them in your Budget.  These are Wants and, with rare exception, not appropriate to consider as investments for your Financial Security.

Tulip Mania

One of the most famous examples of where the price of non cash flow generating assets went completely crazy was in 1637, referred to as “Tulip Mania”.  Before we visit the Tulip Mania story let’s explore a bit of background to help put this into context.

Tulip bulbs are planted in the Fall and flower in the Spring.  Amazon sells bags of 25-50 Tulip bulbs today for somewhere between $.60-$1.00 per bulb.  If you were a gardener and liked Tulips you could exchange $50 of cash (an asset) and purchase somewhere between 50-80 Tulip bulbs (also an asset).  The value you would get out of Tulip bulb assets would be in the joy you would feel working in the dirt and admiring the flowers.  At the end of the season you would dig your bulbs up and store them in a cool dry space and plant them again in the following Fall.

If you were a Tulip farmer, you might sell your flowers to local markets and some of your bulbs each summer to Amazon who, in turn, would sell people like me bulbs at $60-$1.00 per bulb.

In 1637, something crazy happened

In the country of Holland, in 1637, something crazy happened.  Seriously, it’s extremely hard to get your head around this so sit down before continuing to read more.

In the late 1500’s and early 1600’s it became fashionable for wealthy people to give gifts of rare tulip bulbs.  I won’t regurgitate the details because you can click on the link above or do a Google search to read many articles.  The gist is that what started out as a niche form of collectible turned into one of the biggest asset price bubbles of all time.  At the peak of the frenzy in 1637, one rare tulip bulb was said to be worth the equivalent of an Amsterdam mansion.  A single tulip bulb might be traded up to six times per day and there was a month in early 1637 when the price of certain tulip bulbs increased over 1,000%.

It’s pretty obvious that the value of a tulip bulb today from Amazon is worth a lot less than an Amsterdam mansion but from time-to-time, throughout history, the price of assets explodes well beyond the value.  It can happen to assets that have intrinsic value and those that don’t.  When the price of assets goes up the Speculation frenzy kicks in.  You will be well served to avoid jumping into this quagmire for, when the music stops, there are many poor and broken people.  Do we have a version of a modern Tulip Mania happening today?  Maybe.

Crypto currencies are highly speculative and should not be part of your Investing Wisely plan…in my opinion 

In my opinion, crypto currencies are speculative and you should be prepared to lose a substantial, possibly all, of your money.  Watch out for Cyrptos.  With assets that have no intrinsic value there is even a greater opportunity for asset bubbles to occur.  I believe in the technology of the blockchain and expect that the technology will be disruptive to many businesses that exist today.  I do believe that crypto currencies are highly speculative assets that should not be part of an Investing Wisely plan.  Cryptos have been used for money laundering, ransomware and a host of illegal activities.  I expect that governments will create policies and regulatory oversight such that the future price has a material risk of being much lower than the prices that are reflected in today’s world.  I could very well be wrong and I may change my mind at some point. 

The fact that your crypto is subject to complete loss if you lose your private key or your wallet gets hacked is problematic at best.  You get a head injury in an accident, forget where your private key is…you are out of luck.  You have dementia and lose your private key…you are out of luck.  Nothing backs up the value of crypto other than the price the next person is willing to pay.  There are a lot of people who have a tremendous exposure to crypto currencies just like people in Holland had to tulip bulbs. There are many people who make money off of people who buy and sell cryptos who serve as cheerleaders for owning cryptos.

Be careful, be very careful.