Price v Value By: Roger Montgomery
Many investors experience losses and some experience losses that are larger than others. There is however a happy band of methodical investors, whose losses are minimized and returns almost certain. These investors are value investors and focus on the underlying business as separate to the trading price.

Academics correctly observed that the market was frequently efficient but they perhaps incorrectly concluded that the market was always efficient. This simply cannot be true. EMT is based on the assumption that all investors act rationally and that they are profit motivated. Unfortunately for academia this assumption, while neatly allowing the acceptance of EMT, fails to reflect reality. Markets are not efficient because investors have consistently, throughout history, failed to act rationally. For all our seeming sophistication, we can at certain times behave as independently as sheep. Indeed an oft-used quote by Edgar R. Fiedler from his book, The Three Rs of Economic Forecasting-Irrational, Irrelevant and Irreverent, June 1977 is;

"The herd instinct among forecasters makes sheep look like independent thinkers. " 

At extremes of euphoria and pessimism, individuality takes a back seat. It is at these times that the share prices of businesses are pushed well above or well below the true value of the underlying business and while infrequent this is where the greatest and most certain opportunities are found. 

Consider for a moment you are a business owner. You run the local newsagent or Bakers Delight store. Now let me ask you a question? When you wake up in the morning, do you determine whether the business is going well or poorly by looking at the performance of the share price? Of course the answer is no - there is no share price! And so your assessment about the ongoing viability of the business is based on an understanding of the profits the business is making with reference to the business's assets, equity and debt levels. The same should be true of businesses listed on any stock exchange, but this is rarely the case. Investors in businesses that are listed often forget the business and look only at the direction of the pieces of paper that wiggle on a computer screen.

When an unlisted business is bought outright, an estimate of its value is made and the purchase price is often equal to that estimate of value. Rarely does an educated buyer pay significantly more than the value of the underlying business. In the stockmarket while the value of a business may change infrequently, the price fluctuates every day and so prices can trade well above the underlying value or well below. When price drops well below value a buying potentially extremely profitable buying opportunity is presented. 

The job of an investor is then quite simple; buy shares in an outstanding business at a price that is less than the value presented. All that remains is to establish the value of a business. You may be surprised to know that is quite simple to determine the value of a business although the final number is somewhat imprecise. All you need to do is conservatively estimate the future cash flows the business will produce and discount those cash flows back, to the present day using an appropriate discount rate or rate of return.

As an investor, you can immediately place yourself ahead of the majority by simply learning to separate the share price from the underlying value. Once you have established this underlying value, simply sit back and wait for the share to trade below. This is Value investing. As legendary investors Ben Graham, Warren Buffett and Charlie Munger have all said, Price is what you pay and value is what you get. The idea is to get more value than what you pay.

-- Roger Montgomery is the director of Investors Advantage Pty Ltd, which provides trading workshops for corporate and private investors. For information, call 1300 135 532.