The difference between price and value

There's a difference between the price of Commonwealth Bank of Australia (ASX:CBA) shares and their value.

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There's a difference between the price of Commonwealth Bank of Australia (ASX: CBA) shares and their value.

The difference between price and value

Warren Buffett famously said, "price is what you pay, value is what you get."

You can see this playing out in the sharemarket each day. We are so concerned with the price of things. Telstra Corporation Ltd (ASX: TLS) shares have fallen 3% today — run for the hills! National Australia Bank Ltd. (ASX: NAB) shares are up 2% — buy, buy, buy!

Watching the price of something change impeaches our better judgement. Our emotions jump all over the place.

Most of us find it too hard to think rationally when prices are moving. Have you ever been to a Costco, or Chemist Warehouse? How did the prices make you feel?

Despite watching the market every day, one way I keep a lid on my emotions is by thinking of the sharemarket as the business market. After all, shares are just part ownership in a business.

And you don't see successful business people running around like headless chooks. They can't see the price of their business change every day.

But one thing all successful businesspeople understand is the value of their operation. Value doesn't change anywhere near as frequently as the price.

Price is what are asked pay, value is what we are willing to pay.

If the market says to you, 'I'm freaking out, please, buy my Telstra shares for 5% less' you shouldn't feel compelled to buy them. Just because you are asked to buy shares, doesn't mean you should.

However, if you value those Telstra shares more than what they are worth, you should be willing to pay up.

Unfortunately, the market and other investors do not offer this opportunity very often. Therefore, it's important to go into the investment knowing what it's worth, having done your research.

Otherwise, it would be like going to a car yard without a budget. Or deciding to buy your local cafe — when you were supposed to bring home two skinny lattes.

If you don't know something's worth, it's a bad idea.

So how do you determine a share's value?

As much as you can try, you will never know exactly what shares in a company are worth. Sure, you may have all the valuation skills in the world. But valuation is an art. It's an expression of your biases and beliefs.

And these two things are affected by many other factors, such as the time you have to invest, your goals and your temperament.

Analysts use common techniques like discounted cash flow (DCF) analysis, earnings capitalisation and private equity multiples to come up with a value for shares.

However, most — if not all — of the analyst 'price targets' (aka valuations) that you see in the financial media are written by sell-side analysts. These men and women are paid to research the business. They could be great analysts, but they are not necessarily seeking to buy or hold the company's shares — as an investor does. 

That's why I prefer to do my own research or follow the guidance of investors who share similar belief systems.

Foolish Takeaway

I often get called out for recommending companies then their share prices fall after announcing something worse than expected — usually a short-term hiccup. But the rises and falls of prices mean nothing to me in the short-term. As Warren Buffett's mentor Ben Graham famously said (and I paraphrase), 'in the short run the market is a voting machine, in the long run, it is a weighing machine'.

What he meant was that prices move markets in the short term because it's the popular thing to do (e.g. marijuana stocks). However, in the long run, it's value that counts. It's value that will make you money.

It's important you know the difference.

Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any company mentioned. Owen welcomes and encourages your feedback. You can follow him on Twitter @OwenRask. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Costco Wholesale, National Australia Bank Limited, and Telstra Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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