What is a stock market crash?
The difference between price and value is an important concept.
In the words of the world's most famous investor, Warren Buffett:
"Price is what you pay, value is what you get."
Another great quote is:
"Price is what you are asked to pay, value is what you are willing to pay."
Everyone's assessment of value is different. For example, a $1,000 iPhone might seem expensive to us, but you might think it is great value.
Typically, we buy an item or invest our money if value is greater than price.
How is the value determined?
In finance, an asset's value is determined by investors, analysts and economists using financial models. Some of the most common valuation models include:
- Discounted cash flow (DCF) analysis, which uses forecasts of free cash flow
- Ratio analysis (e.g. the price-earnings ratio)
- Arbitrage pricing theory (APT)
- Relative valuation (e.g. property one versus recent property sales in the area)
In investing, the final value is often called the 'intrinsic value'. However, stock analysts also call these valuations their 'price targets'.
The price of an investment can change by the minute or second, but the intrinsic value changes less frequently (e.g. the value of an iPhone changes less frequently than its price!).
Test Your Knowledge
The price of a share is $100. Sarah values it at $110. She is likely to:
Price is what we are asked to pay, value is what we are willing to pay. Because the value ($110) of the share is greater than the price ($100), Sarah is more likely to buy the share than sell.
True or false: "Value is what you pay, price is what you get."
It looks like that sentence was the wrong way around. Price is what you pay, value is what you get.
Tim owns a 3 bedroom brick house at 2 Overpriced Lane, Sydney. His real estate agent said his house is worth $1 million. However, two identical houses, at number 1 and number 3 Overpriced Lane, just sold for $500,000. Tim...
Relative valuation takes the value of similar (or identical!) assets to value another asset. In this case, the valuation of Tim's house appears to be too high.
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