As I mentioned in a recent article, investments (such as stocks) have both a price and a value.  A stock’s “price” is the amount at which a buyer and seller most recently agreed to trade the stock. It is purely objective and 100% ascertainable for publicly traded stocks.  However, the fact that IBM trades at $148 a share when AAPL trades at $98 a share does not make IBM’s stock better or more valuable.  In fact, when you take the price of each company times the number of shares, AAPL as a company is nearly four times more expensive than IBM.  IBM’s stock is more expensive per share only because it has many fewer shares than AAPL.

A stock’s “value”, on the other hand, is subjective.  It is what the investor believes the price of the investment should be.  For example, Morningstar believes that the value of AAPL is $133 per share as of writing.  There are about as many opinions on the value of any given stock as there are people giving the opinions.  The same thinking applies to a group of stocks, such as biotech stocks or the U.S. stock market as a whole. So when you hear someone say that a stock is undervalued, now you understand that the person believes that the price of the stock is less than its value, and vice versa for overvalued.

For the most part, investors are poor, unlucky or both at assessing the value of investments, or at least at being patient enough to give themselves a chance to be right.  Even the brilliant minds running mutual funds have failed to successfully buy undervalued stocks and sell overvalued stocks on a consistent basis, since they do not beat the market in the long-run after adjusting for risk.

On the other hand, searching for undervalued stocks is a compelling adventure, because 1) if someone is consistently right (or lucky) then they will receive potentially significant gains; and 2) almost everyone believes that they are smart enough to successfully identify undervalued stocks and disciplined enough to wait for the price to catch up to the value. Warren Buffett and many others have become extremely wealthy based, in part, on their ability to successfully identify undervalued stocks.

Finally, it is important to understand that all of this undervalued stock talk flies in the face of the efficient market hypothesis, which was very popular when I was in Law/MBA school.  The efficient market hypothesis is that a stock’s price and its value are the exact same at all times, so there is no such thing as an undervalued or overvalued stock. This hypothesis has been largely discredited by the field of behavioral finance, which illustrates ways in which the market does not behave rationally and that at times the value and the price of a stock can be vastly different. Another contradiction is that stock returns tend to reverse over long periods of time (i.e. winners become losers and vice-versa), which tendency is significant and cannot be explained by the idea that price = value.

In my next article, I will describe some of the methods that people use to value individual stocks and groups of stocks.

-Richard

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