George Bernard Shah once said that a cynic is a person who understands the price of everything but the value of nothing. That is more at a generic level. What do we understand by price and value when it comes to stock markets and more specifically with respect to equities? Let us look at this debate between market value vs stock price and probe the difference between stock price and market price. Value and price of stock are two sides of the same coin and one is not possible without the other.
Price is what you pay and value is what you get
This is perhaps the most basic difference between the concepts of price and value. When you buy a product or a stock, there is a certain market price that you pay. Especially, when it comes to stocks, market price is based on a mix of subjective and objective factors. What you actually pay for the stock is the price or the market price of the stock. But value is what is resident in the asset. Value is derived by what the stock worth, which in turn is dependent on how much cash flow the company can generate in the future. There are two types of price viz. cost price and the market price. The cost price is the price at which you procure the stock while the market price is what the stock is currently quoting at in the current market. Normally, the difference between cost price and market price is determined by estimates of value.
Value is of two type’s viz. embedded value and cash flow value. Gold is valuable because there is value in the form of precious metal embedded in gold. Gold does not generate cash flows. Cash flow value arises when an asset can generate cash flows in the future. For example, a stock can generate cash flows in the form of dividends and capital gains. A business can generate free cash flows from operations and property can generate rent.
How is value estimated in the stock markets?
While there are many methods of valuing stocks, the most popular method is the discounted cash flow method. Here the future cash flows of the company for next 5 years are discounted back to the present using the weighted average cost of capital (WACC) as the discounting rate. Additionally, the lump-sum terminal value of the business is calculated at the end of 5 years and that is also discounted back to the present. The sum total is the valuation of the company. The following formula captures the concept of valuation based on discounted cash flows best:
Normally, the valuation considers the next 5 or 7 years where it is possible to project the cash flows and then calculates the final value. The logic of this approach to valuation is that the value of any business is dependent on the cash flows that it can generate in the future. Valuation is, therefore, all about the capacity of the business to generate cash flows in the future.
How is price determined in the market?
When it comes to price of a stock, there is the all-important concept of the P/E ratio that we need to understand. It is the ratio of the market capitalization to the net profit of the stock. It represents the price that the market is willing to pay for every rupee earned by the company. Normally, investors tend to believe that price is the input and P/E ratio is the output. In reality, P/E ratio is the input and price is the output. The P/E ratio for a stock or a sector is dependent on a variety of factors like quality of cash flows, balance sheet strength, brand value, corporate governance standards, ability to scale up etc. For example, sectors with high ROE and growth like FMCG enjoy a higher P/E compared to metals and other commodities. It is the P/E ratio that actually determines the price of the stock.
The relationship between price and value
The big debate in equity markets is what stocks to buy and at what price. That is where the linkage between price and value comes in handy. Consider the graph below:
Normally, there is a direct relationship between value and price. Greater the value, greater the price and vice versa! The above chart captures the essence of value creation and value destruction. When the price is substantially above the value of the stock, then the stock is likely to be a loser and therefore destroy value. On the other hand, if the price of the stock is substantially below the value then it is likely to outperform and create value. The gap between the price and the value is the margin of safety and is commonly used by marquee investors like Warren Buffett to evaluate the attractiveness of a stock.
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