Price and value are two terms which unfortunately all too regularly get used incorrectly particularly by investors who are new to the stock market. Who hasn't heard somebody exclaim "Wow, company X is only 20 cents a share, that's cheap".
In this case, the novice investor is likely to not understand the concept of value. The low price has given him or her an expectation that the company is cheap, however the price is simply the outcome of an auction process between buyers and sellers.
Meanwhile, assessing value requires deep thought and consideration of the company's business, its ability to generate cash and in turn what a reasonable person would be prepared to pay for those future cash flows.
Mastering these concepts of price and value is essential to long-term investing success. As investor Howard Marks once noted:
"The positives behind stocks can be genuine and still produce losses if you overpay for them"
This is a trap many investors find themselves in. They are blinded by the excitement and positive outlook for a company but fail to pay due attention to fair value. One quick check that can be used to help avoid overpaying for a stock – although it is far from foolproof – is to compare the multiple it is trading on with its peer group.
The following three companies are all great businesses. They are well managed and have good long-term growth potential, however, that doesn't mean they are good stocks to purchase at current prices.
Indeed, paying up for quality is one thing, but overpaying can be hazardous to one's wealth!
Domino's Pizza Enterprises Ltd. (ASX: DMP) is trading on a financial year (FY) 2016 price-to-earnings (PE) ratio of around 60 times. In comparison, the consumer discretionary sector trades on a forecast PE of about 21 times.
Cochlear Limited (ASX: COH) is trading on a FY 2016 PE of approximately 31 times, compared with the wider healthcare sector's forward multiple of 25 times.
REA Group Limited (ASX: REA) has a forward PE of 31 times. In contrast, the consumer discretionary sector has a PE around 21 times and the information technology sector has a forecast PE of 23 times (all forecasts provided by CommSec).
Foolish takeaway
Investors who clearly distinguish between price and value will also acknowledge that they can't accurately value everything.
Even investing legend Warren Buffett acknowledged this when he said – "If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility."
