Price has no value

“I bought this house/gold/stock at this price – what do you think?”  Let’s look at this question, price in itself has no information. If we say cost of petrol is x, can we say whether is it high or low? Of course if you are a buyer, any price can be too high and if you are a seller any price can be too low, but price of something in itself does not indicate its value.

Price is what you pay. Value is what you get” – Warren Buffett

Price always needs a reference to determine value. For instance

  • Reference to a basket: If one was spending 1% of their income on petrol and it went up to 1.5% then we can say the price of petrol has gone up.
  • Reference to another commodity: Price of a litre of petrol was 1.5 times that of diesel and now it is 2 times that of diesel – then we can say that petrol has become relatively more expensive as a fuel.

Reference to the historical price may not be very useful – if one said the price of gold was x, 10 years ago and is y now – this still does not give us any useful information unless we know about the overall price inflation. This is especially true for things that are not income generating – for instance gold. Gold price increase can be in reference to inflation. Another reference for gold could be an alternate opportunity, for instance current value if the same money was put in a bank deposit 10 years ago.

For a “non-income generating asset” the reference can be inflation or an “equally safe” alternate opportunity. Price for a non-income generating asset is based on the relative appreciation over its reference. One can justify a higher price only if there is higher the relative appreciation.

Evaluating prices of Income generating assets is a bit more interesting. We should treat its value as sum of Income yield from the asset and a relative appreciation by treating it as a non-income generating asset,

Income yield = yearly income/price – key here is to make sure income and price are at same point in time. Income yield shows the income generating power of the asset.

  • For a house – Income yield for a specific year (a.k.a. rental yield), will be that years rent divided by prevailing price that year. Income and price should be for the same time period.
  • For a stock – income yield (a.k.a dividend yield) is the dividend received that year divided by the prevailing price of that year.

For an income generating asset sum of the income yield and the relative appreciation can be compared with inflation or an “equally safe” alternate opportunity.

Similarly GDP of a country in itself has no meaning – it needs to be compared with GDP of the world or of other countries. Level of the stock market index in itself has no meaning, it should be evaluated in reference to the earnings of its constituent companies.

Price itself has no value – it always needs a reference. Finding the right reference is the key to determining value.

 


 IndusWealth:Making your money work for you

About Praveen Reddy

http://in.linkedin.com/in/praveenreddyinduswealth

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