A few weeks ago a question about value and price that Mr. Divnomics had in one of his classes set off an interesting discussion. We talked about this subject and questioned ourselves if value and price were actually the same things. Or are based on different kinds of fundamentals. The outcome of that class was that price and value were the same things, which we both disagreed on. His teacher loved the discussion going forward and had planned a new discussion on the next class with some upfront preparation.
In order to get some more thoughts and opinions on this topic, I wrote a blog post on our thoughts of the matter. And there were great replies that made us think about our view towards value and price.
Last weekend the second class took place, and another discussion with the group got to a very interesting conclusion.
A quick look back
The discussion started with the class Wealth Management Mr. Divnomics is following. They asked the question if price and value were the same. The whole class answered with yes, except for my lovely boyfriend of course. At home, we talked about the subject some more and came to the conclusion that price and value are often seen as the same concept, but we had some thoughts that spoke against it. Like when you sell a home, the price you get can ultimately be different than the value the real estate agent had calculated for it. To be clear, there are different types of value to be found. In this article, I’m talking about market value.
I wrote a blog post about our thoughts on the matter, in the hopes gaining more insights from readers how they looked at it. And we searched online to get more info on the matter. So, when the next class was attended he would be more prepared to answer.
Based on the comments, most of you were on the same page: Price and Value are mostly the same. Most of you stated that when you buy something for a certain price, this also determines the value of the underlying asset. With one difference: the definition of value is adherent to the perception of the one that is given value to an asset. Or as Full Time Finance said:
The issue is, value is relative. Every person has a different value for something and your value and thus the price your willing to pay may be different than someone else.However, there is an aspect that price in the market is determined by the intersection of the supply and demand curve. This means the price something sells at is usually the aggregate of the market’s view of value, rather than your individual value. That’s where the difference lies.
And Michiel mentioned something else that was very interesting: the water-diamond paradox.
It’s also known as the paradox of value and is the apparent contradiction that, although water is, on the whole, more useful, in terms of survival than diamonds, diamonds command a higher price in the market. – according to Wikipedia
Once that was explained by Smith, the founder of this principle, that the value of an asset was determined by the amount of labor that was needed to acquire it. Water, for example, is very easy to come by, whereas diamonds are very rare and not more labor in order to get a hold on. The paradox lies in the explanation that water has a high value in use, many people need it to survive. And diamonds has a low value in use, but a high value in exchange. People are willing to open up their wallet for it.
Price in this view was correlated to the labor that was needed. On the other hand, in the more mainstream economics people explain value as determined by the view of the consumer, if the demand is higher the value will increase accordingly.
Further insights on Value and Price
In the financial industry, you have different theories that claim either to be one side or the other when it comes to price and value. The first is that price and value are equal, and the other claims they’re not. One of these theories is called the castles in the air theory. Burton G. Malkiel mentions these approach on value in his book, A Random Walk Down Wall Street, and explains them like this:
Castles in the air
The castle in the air theory of investing concentrates on psychic values. John Mayard Keynes, a famous economist was of the opinion that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyze how the crowd of investors is likely to behave in the future. And how during periods of optimism they tend to build their hopes into castles in the air.”
In other words. People tend to valuate an asset based on how others perceive it. For instance, when you have to value art. You don’t valuate that painting based on how much effort (labor) it took the artists, rather than you anticipate on how the public will react to it. If you think the common people will perceive the painting as a masterpiece, you will give a high value. And the other way around. It all depends on what the fool is willing to pay for it.
Oskar Morgenstern argued even that searching for intrinsic value was nothing more than an illusion and impossible to catch. The value of an asset if determined by an actual transition, or:
Res tantum valet quantum vend potest – A thing is only worth what someone else will pay for it.
For a while now we are following the online lessons of Aswath Damodaran on Youtube, a professor in corporate finance and valuation at the Stern School of Business in New York. In one of his video’s, he’s getting to the core of price and value.
He’s claiming that many are using the terms value and price interchangeable. Which is only possible when markets are behaving in an efficient manner. And we all know, markets aren’t in any way behaving efficiently and actually do make mistakes, a lot.
Basically, there are two types of valuation, intrinsic and fundamental. Where intrinsic value is a function of the expected cash flow, future growth, and possible risk. The fundamental value is about the intersection of supply and demand.
Price, however, is not the same as value. This was eventually the same outcome of the class Mr. Divnomics attended last weekend. The discussion began with the statement that price and value were the same things, concerned with market conditions. This is because markets don’t work efficiently.
So, the conclusion of that lesson was that price and value are the same when markets behave efficiently. But because markets do not behave like that, price and value can differ. However, the calculation of value is always subjective.