Many friends are not alone in their misconceptions about stock prices. Many investors believe that if the stock price is low, then it is cheap, and if the price is high, then the stock is expensive. The assumption here is that the price of a stock is an accurate reflection of the company's value. Out of context, non-investors might assess stock prices in the same way they assess the prices of other consumer goods (such as shoes). You can buy a pair of sports shoes for 20 yuan, or you can buy a pair of Nike MAG Back to the Future shoes for 24,000 yuan. We can agree that the 20 yuan trainers are cheap, and the 24,000 yuan trainers are very expensive. This is because our concept of the value of something is based on our ability to measure the price and value of consumer goods. We think harder when spending 1,000 yuan on a physical item (or service) compared to spending 10 yuan.

Because this is how we think, and we often make these judgments in our daily lives, it is natural to extend this logic to stocks. In our view, stocks under 10 yuan are cheap, and stocks over 1,000 yuan are expensive. But this is not true. Understanding the significance of stock prices is important because stocks are different from any other product or commodity we buy. The only commonality between the price of a company's shares and the price of consumer goods is the unit of measurement they express. When the stock price is below its intrinsic value, the company is cheap or undervalued. On the other hand, when the stock price is above its intrinsic value, the company becomes expensive or overvalued. Let's break it down to understand the meaning of these terms.

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What is a stock or share?

If you own a share in a company, it means you have the right to a portion of the company's future profits (or, in the case of liquidation, a portion of its remaining assets). You can own shares in a company even if the company's shares are not publicly traded. Family businesses work in this way, for example: family members own a certain percentage of the business, usually expressed in percentages. However, in the legal documents of private companies, ownership is represented in shares, just like publicly traded companies. Publicly traded companies typically have millions of shares outstanding. The percentage of the company you own is the number of shares you own divided by the total number of outstanding shares. Outstanding shares can be found on the profile page of each company on securities firms.

What is the stock (or share) price?

The stock price is the price of one share of a company.

The price of a share indicates the market's perception of the company's current value as determined by buyers and sellers. It represents the price at which the stock is traded. In other words, it is the price agreement between the buyers and sellers of the stock – both the highest price the buyer is willing to pay and the lowest price the seller is willing to accept. This also means that the number of buyers and sellers is important. If there are more people willing to sell stocks than those willing to buy, then the price will fall. If there are more people willing to buy stocks than those willing to sell, then the price will rise. The stock price depends not only on what the company is doing but also on the feelings or emotions of the buyers and sellers. These feelings are usually completely unrelated to the value of the company.

What is intrinsic value?

Intrinsic value is an estimate of the true value of a company, based on an analysis of its financial position, earnings, and growth prospects. It is a theoretical construct that represents the value that an investor believes a company is truly worth, as opposed to its current market price. Intrinsic value is often calculated using various valuation models, such as the discounted cash flow (DCF) model, which takes into account the company's future cash flows and discounts them back to their present value. When the market price of a stock is significantly lower than its intrinsic value, it may be considered undervalued, and vice versa for overvalued stocks. Investors often use intrinsic value as a benchmark to determine whether to buy, hold, or sell a stock.The value or intrinsic value of a company is a measure or assessment of the company's worth. The most important thing to remember is that the value of a company is always an estimate, and there is no single answer or number that can capture value. It is a probabilistic assessment by human analysts of the possible outcomes the company may achieve in the future. No one knows the future of anything, but given the risks and rewards of investing, evaluating possible outcomes is a worthwhile activity. Our fair value estimate is the result of a rigorous process we use to analyze companies. The fair value estimate is a yardstick for determining long-term intrinsic value. It tells investors what we believe the long-term intrinsic value of the stock is and helps them see beyond the current market price. Our equity analysts calculate the company's fair value estimate based on how much cash we think the company will generate in the future. When determining the fair value estimate, we also consider the predictability of the company's future cash flows.

Understanding the Key to Stock Price and Value

In many cases, the stock price does not accurately reflect the intrinsic value of the company. Stocks often trade below or above their intrinsic value. Therefore, looking only at the price when deciding to buy a stock is useless because:

(a) Investing is not spending, (b) The unit of the "thing" purchased when buying a stock is the present value of the company's future earnings. Let's look at some examples.

Company Economic Moat Price Fair Value Estimate P/FV Morningstar Rating Consumer Verdict Investor Verdict Berkshire Hathaway B $2,082 $280.91*** Seems expensive, but cheaper than BRK.A. Fairly priced; slightly discounted. Its price and valuation are actually the same as A. Berkshire Hathaway A $31,341 $42,500.91*** Too expensive! They must think I'm an idiot. Maybe I'll buy some B shares. Fairly priced; slightly discounted. Its price and valuation are actually the same as B. Information Systems Narrow $139.20 $1.40** Looks cheap! Mutual - Very expensive. EBay Wide $37 $26.14* Seems reasonable. I can buy nearly 300 shares for $10,000! At least 40% overvalued. Alibaba Wide $289 $38.90.74**** My blood is too rich! I need nearly $30,000 to buy 100 shares! This is a great deal, especially considering its wide and stable moat.

Data as of August 19, 2020

So, you see, a low price does not mean good value, and a high price does not necessarily mean low value. A classic example of this disconnect is the stock price trajectory of the now-bankrupt Hertz Global Holdings (HTZ). The car rental company started the year well, with a stock price close to $20 per share in February. However, the coronavirus pandemic then broke out. With almost everyone in lockdown, no one needed to rent a car, and Hertz ended up idling about 700,000 vehicles, which meant it had little to no revenue and was burdened with nearly $20 billion in debt. The company was in poor shape and filed for bankruptcy protection from creditors in May 2020. The stock price briefly reflected this downturn, falling as low as $0.56 per share. But then something strange happened. Investors (many of whom were beginners or new investors with little stock market experience) noticed this "cheap" stock price. The feeling was that the price had fallen so low that there was only one way it could go from here, and the price was still rising! So, many investors thought they could make a quick profit on Hertz stock. In just two weeks, Hertz's stock price rose from less than $1 to about $5.5 per share. Then, it immediately began to fall, settling at today's price of $1.5 per share. Through this roller coaster ride, the company's fundamentals did not change. It could be said that the company's intrinsic value was the same as when it first filed for bankruptcy. But this was not reflected in the stock price. Hertz's stock price fluctuated greatly in a short period, up and down, indicating the price that buyers and sellers were willing to pay for the stock, rather than the value of the company itself. In other words, both buyers and sellers of Hertz stock were gambling on the outcome of short-term events - Hertz's bankruptcy protection - rather than investing in the company's long-term prospects.

So, You Want to Be a Stock Picker

Stock price is just one of many factors that investors should consider when deciding which stocks to buy. We look for competitive advantages or economic moats, which we measure with our economic moat rating. Companies with economic moats can fend off competition and achieve higher rates of return on capital for many years to come. We also consider the margin of safety and the company's valuation. As stock pickers, our goal is to find companies that are priced below their intrinsic value - undervalued companies. The stock's rating or "star" can help investors discover truly undervalued stocks. The rating is determined by three factors: the current price of the stock, the estimate of the stock's fair value, and the uncertainty rating of the fair value. The greater the discount, the higher the star rating. Four and five-star ratings indicate that the stock is undervalued, while a three-star rating indicates that the stock is fairly valued, and one and two-star stocks are overvalued. When looking for investments, five-star stocks are generally better than one-star stocks.

Don't Forget the Risk

When investing, one of your main priorities should be determining how much risk to take on. You need to assess your risk tolerance, which can help you understand the best risk to take on in order to maximize your goals. Investors often mistakenly believe that higher risk equates to higher returns. This is a myth. This is only the case in a highly diversified, effective portfolio. These effective portfolios have the highest expected return levels, considering their risks. If you already have an effective portfolio, the only way to increase returns is to increase risk. Remember, this does not mean you will get higher returns, just that you will have a higher potential return. You may also have a higher potential for loss. Before taking on more risk, establish an effective portfolio. Invest in asset classes and diversify within each class.