Price and value are two terms which unfortunately all too regularly get used incorrectly particularly by investors who are new to the stock market. Who hasn't heard somebody exclaim, "Wow, company X is only 20 cents a share, that's cheap".
In this case the novice investor is likely to not understand the concept of value. The low price has given him or her an expectation that the company is cheap, however the price is simply the outcome of an auction process between buyers and sellers. Meanwhile the value requires thought and consideration about the company's business, its ability to generate cash, and in turn what a reasonable person would be prepared to pay for those future cash flows.
Mastering these concepts of price and value is essential to long-term investing success. As investor Howard Marks once remarked –
"The positives behind stocks can be genuine and still produce losses if you overpay for them".
This is a trap many investors find themselves in. They are blinded by the excitement and positive outlook for a company but fail to pay due attention to fair value. One quick check that can be used to help avoid overpaying for a stock – although it is far from full proof – is to compare the multiple it is trading on with its peer group.
The following three companies are all great businesses. They are well managed and have good long-term growth potential, however that doesn't mean they are good stocks to purchase at current prices. (All forecasts provided by Morningstar)
TPG Telecom Ltd (ASX: TPM) is trading on a financial year (FY) 2016 price-to-earnings (PE) ratio of 26.7 times. In comparison the telecommunications services sector trades on a PE of 17.6.
Navitas Limited (ASX: NVT) is trading on a FY 2016 PE of 27.3, compared with the wider consumer discretionary sector's multiple of 16.8.
Carsales.com Limited (ASX: CRZ) has a forward PE of 23. The information technology sector meanwhile has a PE of 17.5.
Foolish takeaway
Investors who clearly distinguish between price and value will also acknowledge that they can't accurately value everything. As Warren Buffett commented in his recent letter to shareholders of Berkshire Hathaway Inc (NYSE: BRK.A): "If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility."
