It is safe to say that Adam Smith was one of the greatest pioneers of modern economics. We hardly see him in textbooks (at least not as much as we’re supposed to) but I assure you that by reading one chapter from any of his works (and by “any”, I mean Wealth of Nations) – you would be enlightened quite much. His masterpiece, from Wealth of Nations, which warrants a quote at this moment goes
“The real price of everything, what everything really costs to the man wanting to acquire it, is the toil and trouble of acquiring it”
A beautiful statement, and a rather important one too, and here’s a good illustration.
What is a diamond worth to anyone who wears it? Nothing! Absolutely nothing. Diamonds are not important in sustaining human life. Then, by logic, they shouldn’t cost anything, let alone be as expensive as they are. From that, we ask, why do they cost so much? That’s a funny story.
A diamond is valuable to a miner because he knows he can sell it to a jeweller. For the miner, the diamond affords him economic means – an essential livelihood. The same diamond is valuable to a jeweller because he can sell it to consumers. The diamond serves the same purpose to the jeweller. Here’s the best part: the value a consumer derives from a diamond is sentimental. Based on perception. Internal satisfaction, is also known as utility in the study of economics. A diamond feels as good as its price. Where does price come from? In general, supply and demand. Diamonds are not expensive because they are somewhat special on a wedding ring. They are just hard to find and super strong so yes, they do have other industrial uses like drilling equipment, but that’s it right there! The cold war of Value vs Price.
Shares are particularly hard to see in terms of value. I can get 15 analysts to value the same company and you’ll probably get 15 different answers. The value of a company is based on a much deeper scrutiny of company dynamics. Revenue, profit, cash flows, liquidity, and some nonfinancial data like growth and sales strategy, governance, relationships and potential reach in a market. It’s a lot. And the answers we find from the “value" tell us about how good the “price” we see is. In a perfect world, we can’t do anything about price. It’s a market reference.
Price is heavily influenced by demand (just people wanting the stock) and volume (the quantities at which people want the stock). Remember GameStop? Price shot through the roof very fast, why? high demand and high volume in a very short time. The real why? Just to stick it to stick to Wall Street. Remember Naspers after listing Prosus? Their stock dived to R1800. Several months later, they are now trading at R3500, why? high demand but not as much volume so price rose steadily over time. So, what is to give Price? Price is easy to manipulate. Investment banks have been doing that for years but that’s a story for another day.
The real investing decision lies in value. Two stocks, from the same industry, might have the same price but one is actually more expensive. How? They are both R100, right? Yes, but the one is not really worth R100. Its value, what is it really believed to be worth, might be R80? So you’re losing R20 on every share you buy. The other might be really worth R110. You’re saving R10 on every share. And that goes a long way to delivering a good portfolio.
So don’t get caught up in the illusion. Do research. Look at what the company is doing (look into understanding an important term analysts use: Corporate Actions).
You don’t need to know how to calculate enterprise value or do a Discounted Cash Flow valuation (Pro tip: Analysts publish stocks they cover along with recommendations on whether to buy, sell or hold stocks – check Moneyweb), but do understand what it means when a company issues new shares, or issued rights or refinances their debt or even the pursuit of buying or merging with another company. All of these things affect value and ultimately, the price you pay for a stock. Happy investing!
Author: Nkanyiso Nyawose