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Price, Value, and a Margin of Safety Between

January 16, 2017

Two words sum up my investment philosophy: price and value. Often price and value are used interchangeably, but they really have two distinct meanings and should not be confused with each other.

  

Loosely defined, price is what a buyer pays to a seller in an arms-length transaction. Price is a short-term concept, as an asset trading hands at a given price now, may trade hands at a very different price ten days (or even ten minutes) from now.

  

Value, on the other hand, refers to all of an asset’s future economic production that will benefit the owners of that asset. Value is a long-term concept, and depends on future events that nobody can predict with perfect certainty.

  

The two concepts of price and value, while different, are of course related to a degree. Price is often negotiated according to buyers’ and sellers’ opinions as to value. And if we say that someone paid too much for something, we imply that the price paid was greater than the value received.

 

Neither price nor value can be ignored by the investor. Both are equally important, as it is the relationship between the two that determines whether an investment opportunity is attractive or not. I consider an investment to be attractive when its price is significantly less than its value.

 

Investing is not an exact science. For while price is knowable with “to the penny” precision, value is an estimate. Valuation methods are imperfect and prone to serious error. And while our world is full of information, I have yet to evaluate a potential investment where I have a perfect and complete set of facts. And even if I did, I still might not conclude correctly. Highly intelligent and rational people sometimes differ strongly as to their opinions of value, even though they often are looking at exactly the same set of facts.

 

It is not necessary to form a highly precise opinion of value in order to make a profit as an investor. The trick is not in fine tuning the valuation model to perfection, but rather in finding opportunities where the gap between value and price is so wide that there is ample room for error. Benjamin Graham, whom many regard as the father of value investing, and later Warren Buffett, referred to this gap between price and value as a “margin of safety.”

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