Price is what you pay, value is what you get

Price is what you pay, value is what you get.

The above quote of Warren Buffett is widely used, but very few of us really understand the true meaning of it.

Majority of investors look at the price as indicator of whether a stock is cheap or expensive, for example, a stock trading at Rs.10 would be considered less expensive compared to a stock trading at Rs.1,000, the reason seems to be simple and pretty obvious, it is far easier for a stock trading at Rs.100 to go Rs. 1,000 than a stock trading at Rs. 1,000 to go Rs. 10,000 isn’t it?

What’s interesting is that this misconception is pretty common among investors, especially those who look at stock price as a guide to making their investment decisions. However, I don’t blame them for this, most of the buying decisions that we make in our life are heavily guided by the price quoted on the product or service.

For example, a car priced at Rs.15 lac may be more expensive compared to one selling at Rs. 6 lac, no matter how feature laden former is. As a result, we have developed a habit of subconsciously associating the value of things with its price.

In fact, many years back, I was no different. When I started my investment journey, this sounded very logical, but as I gained more experienced, (a less embarrassing way to say, after burning my fingers many times) it turned out to be a misconception.

When it comes to investing in stock market, price is the last thing an investor should be looking at, it’s never about price, but as Warren Buffet said(Price is what you pay, value is what you get), it’s not the price but the underlying business and its quality that matters.

Let me give you an example, ICICI bank and HDFC bank are the two leading private sector banks in India, while ICICI bank is trading at a price of Rs. 401.1(as on 25 April 2019)while HDFC bank is trading at Rs. 2,280 (remember both the banks have same face value of Rs. 2 per share).

Note: All data taken from Screener.in 

If I were to go purely by the price of the stock, ICICI bank looks much cheaper compared to HDFC bank, after all, for the same amount spent on buying a single share of HDFC bank, you can by almost 6 shares of ICICI bank.

But consider this, ICICI bank is trading at a price to earnings ratio (P/E ratio) of 42.29 as I write, while HDFC bank is trading at a price to earnings ratio of 29.45. What it means is, you are paying far less for each rupee earned by HDFC bank compared to ICICI bank. That makes HDFC bank far cheaper than ICICI bank.

I know there are people who will think that there is a huge gap between market capitalizations of HDFC bank, which is trading at a market cap of Rs.616, 897 crores while ICICI bank is trading at a market cap of Rs.254,376 crores, and it’s a legitimate concern, so… 

Consider another example, Aditya Birla Capital and L&T Finance Holdings are two holding companies working in the financial sector (such as loans, asset management, mutual funds). Both Aditya Birla Capital and L&T Finance Holdings have a market capitalization (price of the stock multiplied by number of outstanding shares) of around 20,000 crores.

Aditya Birla Capital is trading at a price of Rs.98 at the time of writing while L&T Finance is trading at a price of Rs. 139, just like previous example, it seems like Aditya Birla Capital is much cheaper compared to L&T Finance.

What is also interesting to note is the fact that in the past 1 year, the stock of Aditya Birla Capital has seen sharper decline compared to L&T Finance Holdings, which indicates that former is has better chances of an upswing compared to latter (of course assuming all the circumstances are same)

But again, if you compare their respective P/E ratios, the picture changes completely. Despite steep decline in Aditya Birla Capital, the stock is trading at a P/E of 26.28 at the time of writing compared to L&T Finance Holdings which is trading at a P/E of 13.38. What is the point of all these explanations?

The point is that the stock price alone never tells you the entire story, nor does it tell you whether a company’s shares are cheap or expensive. In order to know that, you must relate the price to something, whether it is earnings, book value (there are many reasons why even these financial ratios do not tell you much about the cheapness or expensiveness of a stock) apart from that, you must also assess the underlying quality of a company and the long term economics of a business.

How Much Lower Can it Go?

Another misconception regarding price is that if a stock has corrected significantly, it becomes an attractive investment, there is a simple logic behind it which goes something like this “The stock has already fallen 90%, how much more can it fall?” and it sounds logical, as a stock that has already been beaten down so much has nothing much to lose and the chances of going up are much higher.

Yes it does happen in some stocks, especially in the small cap and penny stocks, which have very low trading volumes. Such stocks can skyrocket briefly on a news release, a recommendation or a simple rumor. But then such stocks also plunge very quickly.

One such example can be seen in Unitech, a real estate, construction and contracting company which was trading at around Rs 500 at the beginning of 2008. By the end of 2008, it was down 90% to Rs 50 per share.

During this period, there were many investors who though the stock has corrected significantly and will soon rebound to its previous levels, making them wealthy. Unfortunately, that never happened, the stock started hitting lower lows and today is trading at around Re. 1 per share.  

It ultimately boils down to the basic rules of investing, stop using stock price as a guide to the to your investment decision making, let me repeat it again, a low price does not automatically mean cheapness, and thus does not guarantee future greatness. Similarly, a high priced stock does not mean poor returns.

As a quick thumb rule of valuation, always look at the P/E ratio of the stock you are studying and find out if it is cheap or expensive, the simplest way to do it is to take average of 5 years of EPS (Earnings Per Share) and the current market price, and compare the P/E ratio of the company you are analysing with the peers in the sector and its own past record.

Also Read: Why You should Ditch the P/E ratio and use this instead.

If the stock’s P/E is lower than its peers, or from its past, dig deeper to find the reasons behind it. Maybe the business has done worse than its peers, or if its sales and profits have deteriorated, maybe their debt levels have increased.

If you find nothing wrong in fundamentals, the stock deserves a deeper analysis for further study, but never rely on price alone to tell you if the stock is cheap or expensive, and always remember, Price is what you pay, value is what you get.