There is a key to understanding any financial concept, and that is understanding the difference between price and value. It’s a fundamental aspect of investing. So let’s dive in because this one is probably the most important building block to financial literacy.
Price – the amount it would require to purchase something
Value – the quantified importance or benefits of something
In the stock market, there are many ways to decipher the underlying value of a stock. In fact, one ratio is used to determine how “expensive” some stocks are compared to others. It’s called the Price-to-Earnings (P/E) ratio and it calculates the price of a share of stock divided by the net income produced by that company. It measures how much money an investor needs to pay in order to receive $1 of profit from their investment. Companies that have lower P/E ratios are considered to have better value because they are a lower price for the same amount in earnings.
Value is entirely different from price. Value comes from the existence of something unique that solves a problem, and changes based on how the surrounding environment accepts/views it. Changes in the environment are most often the case when dealing with the value of companies – a new competitor offers a better product, their customers no longer have a need or desire to purchase, etc.
The price of a stock changes every single day, yet the factors that make any given company (or any asset) valuable change very rarely. The goal of an investor is to find companies (assets) that are valuable and invest in those that have a low price compared to its underlying value.