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How to profit from the difference between price and value

Choosing which stocks represent value and which don’t can be extremely difficult. There’s no hard and fast rules or a definitive recipe for success because, at the end of the day, the market gives us no guarantees.

However many preeminent investors have shown, over time, that by simply putting the odds of success in your favour, you can make the stock market the best driver for your wealth. To do it, investors need to know the difference between price and value and exercise patience.

The difference is, in theory, very simple. That is, price is what you pay and value is what you get. To distinguish between the two, investors apply historical trends and projections and set a price level or range they feel is acceptable to maximise value. To back your judgement, control your emotions and exercise patience is much harder.

For example, based on historical data and forecasts, I’ve determined the current price for Australia and New Zealand Banking Group (ASX: ANZ) and the price of each of its counterparts including National Australia Bank Ltd (ASX: NAB), Westpac Banking Corp (ASX: WBC) and Commonwealth Bank of Australia (ASX: CBA) is too high. This has eaten away at the value I would realise if I purchased them at their current prices.

Although the stocks could well trade higher in the near term, history suggests investors will be able to get a cheaper price (thus generating greater value) by waiting on the sidelines. This is how patience, controlling the fear of missing out and backing your judgement can lead you to success.

In the case of Challenger Limited (ASX: CGF), I believe depending on your goals, there is a slight chance it is significantly undervalued. Although its shares trade at a cheaper price (with respect to earnings) than the big banks, it’s important to remember it is a slow earner and therefore frequently trades on a lower price to earnings ratio. What we also know is that the best time to buy companies like Challenger (i.e. those whose performances are linked to equity market cycles) is before a stock market rally.

For example, Challenger shares held great value in the first few months of 2013 when they traded below $4.50 but now, at $6.90 per share, investors will be relying on the companies funds management business to keep the price going up in the short term. In the long term, with more Australian retirees demanding annuities and wealth management services, Challenger’s current price will likely seem undemanding. Once again it comes back to determining what you consider valuable and being patient. Remember patience doesn’t lose you money.

When it comes to growth stocks, patience is the key to allowing companies like Yellow Brick Road Holdings Ltd (ASX: YBR) to blossom into something more valuable. At current prices, I feel it holds a heap of long-term value for potential investors and I know in coming years its strong management will enable it to reach its potential.

Foolish takeaway

Time has shown we can all do well in the stock market by simply recognising and acting upon the difference between price and value. Phillip Fisher, the Godfather of Growth, famously said: “The stock market is filled with individuals who know the price of everything, but the value of nothing.”

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Motley Fool Contributor Owen Raszkiewicz owns shares in Yellow Brick Road. 

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