Price And Value

watermoneyI’m going to start this article with the eternal words of Warren Buffett, as written in Berkshire Hathaway Inc.’s (BRK.B) 2008 shareholder letter:

Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.

If you want to be a successful long-term investor in stocks, it’s imperative that you develop and maintain an ability to decipher between price and value. Automatically assuming the sticker price on a stock corresponds precisely with its intrinsic value is a practice that will very likely lead you to disappointment and lost wealth.

I wanted to take a little time today to discuss price, value, and what to do when the prices on stocks change.

Price

What is price? 

Price is simply the amount of money that is expected for something.

Anything with a price on it is available to exchange for money.

You might go down to your local grocery store and see price tags on everything. $1.50 for a loaf of bread. $3.99 for a box of cereal. You get the gist.

All the same, stocks have prices on them as well. They range from pennies all the way up to hundreds of thousands of dollars. Obviously, one might look at stocks at face value and assume that a stock that sells for $10.00 is cheaper than a stock that is trading for $20.00. And at face value, that is correct. In absolute terms, a stock that is selling for ten dollars will cost you less money than a stock that is trading for twenty dollars.

But is the cheaper stock worth less than the more expensive stock?

Not necessarily.

To determine the worth of a stock, one must look beyond the price. One must be able to reasonably come to some kind of conclusion or range about the intrinsic value of a stock to determine whether or not the asking price is a good or bad deal.

Value

What is value?

Value is the monetary or material worth of something.

It’s important to remember here that price and value seldom, if ever, exhibit a 1:1 ratio. There are some people out there that believe all stocks at all times are fairly valued; that is to say, every stock’s price and intrinsic value are always one and the same. However, if that were true how would you explain successful investors that were able to routinely take advantage of mismatches between price and value for years on end? A certain man by the name of Warren Buffett comes to mind here. Buffett himself has argued this many times before, so I won’t belabor the point.

So if price and value aren’t necessarily one and the same, what do we do?

Well, we develop a system that can be used to regularly and reliably value stocks. There are many systems out there. You can look at the price against various performance figures, like the price-to-earnings ratio or price-to-sales ratio. You can compare the price to the earnings growth rate. You can use a discounted cash flow model analysis or dividend discount model analysis. I’ve discussed my methods in-depth already, but you’ll want to develop a system that makes sense for you.

I try to keep in mind that valuing a stock is part art and part science. You’re using hard numbers like sales figures and debt, but you’re also trying to predict growth rates and how sustainable competitive advantages might be. As such, the best one can do is come up with a reasonable range of fair value, and try to buy a stock as far under that range as possible. Doing so would be building in a margin of safety, ensuring that even if a stock is actually worth less than what you predicted you still got a good deal.

What To Do When A Stock’s Price Falls

Now that we’ve established what price and value are, and how they’re not necessarily associated with one another, we can approach stock investing with a rational and logical perspective.

I often talk about averaging down on a stock. This is basically taking advantage of further spreads between price and value, whereby I buy more of a stock at a cheaper price than the previous purchase. If I value a stock at $50 per share and the market is offering each share at $40 I’m a happy camper. So let’s say I buy 100 shares of this stock. And let’s say a month later the market is now offering the stock at $35, but the original thesis hasn’t changed. Meaning, the fundamentals of the company are the same as they were a month ago. What is my state of mind?

Well, I should be celebrating!

I just paid $40 for something that I believe is worth $50. And now you’re telling me I can get it for $35? I must be the luckiest man on earth. At this point, I’m most likely buying more shares.

And I’m not just writing this. You can see that I did this with Target Corporation (TGT) in January and February of this year. And before that I averaged down on Digital Realty Trust, Inc. (DLR) in August and October of last year.

But one must consider capital availability and overall portfolio construction, as I wouldn’t recommend loading up one stock (even if you thought it was a deal) to where it’s an overwhelming portion of the portfolio. Diversification is always important, because it’s always possible that your valuation was incorrect, or the business does not perform as expected.

I’ve also discussed before why I look forward to seeing the shares on stocks I already own fall in price. Even if I don’t have capital or portfolio space for a particular stock at the time, a cheaper stock still has benefits.

However, not every stock pullback is an opportunity. Just because a stock falls by a certain percentage does not necessarily make it a good purchase.

For instance, let’s say Company ABC’s stock is selling for $50 today. Tomorrow, there’s a storm in Idaho or something else equally meaningless to the issue at hand and Company ABC’s stock is now selling at $40. That’s a 20% haircut overnight. Must be a steal now, right?

Not necessarily.

You have no idea what the stock’s worth, or intrinsic value, is. So you cannot possibly know if it’s a good deal or not. You have to fully analyze the company and come to some kind of reasonable range of value before expounding on its worthiness as an investment at the new price.

Be careful with that. 

Furthermore, a stock may fall substantially in price due to deteriorating fundamentals. This can be an opportunity, or a trap. It all depends on whether or not these deteriorating fundamentals are the result of a long-term problem with the company or market they operate in, or if it’s just a bump in the road. It can be exceedingly difficult to differentiate between real, lasting problems and short-term hiccups, which further places importance on diversification.

For example, my aforementioned averaging down on shares in Target occurred after the company announced a major data hack and disappointing results in their Canadian segment. I felt these issues were rather transient, but others might disagree. I believe the data breach will be far behind us in a year or two, and the Canadian stores represent a fraction of their overall business. But there’s still the lingering issue where consumers are increasingly shopping online.

So there’s uncertainty and risk there. But that’s exactly where some of the best investments can be had. The greater the risk, the greater the potential reward. However, it’s important to weigh these risks and potential rewards, and diversify your portfolio accordingly. Furthermore, one major benefit of investing in companies that pay increasing dividends (like Target) is that you’re paid to wait while operations (hopefully) improve. Every dividend payment is a collection of cash, and a reduction of your capital at risk in the market.

What To Do When A Stock’s Price Rises

Averaging down is probably easy, right? If you like a stock enough at $X to buy it, then you probably love it at less than $X.

But what do you do when a stock goes up in price?

It’s funny because us value investors that focus on rising dividend income generally look forward to falling stock prices, as I described above. This allows those accumulating assets to buy cheaper stocks with higher yields on them (price and yield are inversely correlated). A higher yield means more dividend income for the same amount of money. And more dividend income gives your future compounding a bigger tailwind, effectively allowing you to roll your snowball downhill at a faster rate.

This is probably strange to casual onlookers. It would seem that most investors out there are focused only on the value of their collective investments. As such, an increasing value is good and a decreasing value is bad. This rather simple approach doesn’t really get at the heart of true long-term wealth creation, where one would do well to accumulate high-quality assets at prices cheaper than what they’re truly worth. A reassuring feeling that can wash over you when times are good and your accounts are all up can be very expensive, relatively speaking.

When stocks go up, us value investors might cringe a little. And that’s simply because we know that great assets are harder to purchase, as they would then require more hard-earned capital.

But not all is lost. Great businesses will sell more products and/or services as time goes on, as we would expect them to. As such, their profits will rise, and the businesses will become more valuable. This is what we want when we invest in high-quality companies. So it is inevitable that the market will recognize this quality and assign a higher price to equity in these businesses. This is a natural course of life and investing.

However, the key is to pay attention to fundamentals, not prices. As always, you should rationally decide for yourself what an asset is worth, instead of relying on the market to tell you this.

I’ll show you how this works in real life.

I initiated a position (before this blog went public) in Philip Morris International Inc. (PM) on 1/7/11 for $56.22 per share. Meanwhile, the previous twelve months of earnings were $3.92. So I paid $14.34 for every dollar in profit Philip Morris was able to generate over the prior twelve months of operations.

I then added to my position in the company in October 2011 for $62.51 per share. So PM went up, which caused me to pay more for further equity in the company. However, profitability had also increased. The prior twelves months of earnings had increased to $4.72. So I paid $13.24 for every dollar in profit that the company had generated over the prior twelve months of operations. I paid more per share in absolute price, but less on a basis relative to underlying profitability.

I built my position in Philip Morris International over the course of five separate transactions, with the last one seeing me pay $79.14 per share in January of this year. We can see that PM finished 2013 with earnings per share of $5.26. So I paid $15.04 for every dollar in profit the company had generated over the prior twelve months.

So you can see how even though PM’s share price had advanced substantially over the years along with the broader market, so had its earnings power. I was happy to pay just a little more for every dollar in earnings in early 2014 over what I paid in late 2011, considering how much the broader stock market, and PM’s share price with it, had gone up. We keep hearing about how expensive the stock market is and how a correction is coming any day now, but you can see here that I paid a very similar price relative to earnings power and value for PM’s stock in both early 2011 and early 2014.

Price is meaningless without some relativity to value. Price is but a number. Value tells you how much a stock is actually worth.

In the above example, I paid attention to Philip Morris International’s fundamentals rather than absolute price, and felt its intrinsic value had increased over the past few years, thus rationalizing a higher price. Its earnings power had increased substantially, and the company had gone from paying $2.44 in dividends during the year of 2010 to $3.58 throughout the year of 2013. That’s an increase of 46.7%, or a compound annual growth rate of 13.63% over that four-year stretch.

So of course I was willing to pay more for the company. The fundamentals were better. The company was earning more, and paying me more of that increased profitability via larger dividends. Now, there is more to a company’s fundamentals than just earnings and dividends, as I’ve discussed numerous times. But you can see here why PM’s stock was worth more, thus making me feel comfortable with paying more. The price had increased, but so had the value. Thus, on a relative basis it wasn’t a lot more expensive.

Now, if a stock’s price rises to a point where it’s irrational and the underlying value has not increased in a likewise fashion, then it would obviously not be advantageous to buy more shares. In fact, if the price becomes too irrational one might be better served selling, while looking for a better opportunity later to re-enter that investment when price and value are more advantageously correlated.

You always have to weigh your risk against the potential reward. And the lowest risk and greatest reward is present when the price and value are furthest apart to your favor.

Conclusion

Price is just a number, an amount of money that is expected for something. Without value, it’s impossible to quantify whether a price is fair, cheap, or expensive.

However, I also don’t believe it’s possible to exactly and precisely determine the value on a stock. Rather, you will want to reasonably estimate the intrinsic value on a company, and what each share might be worth. A tight range is probably appropriate, though I use a dividend discount model analysis to put a round number on it. Although, one should always strive to buy even below this range, as it ensures a margin of safety in case your growth estimates are wrong, the company does not perform as predicted, or the broader market all of the sudden decides to discount that particular stock or all stocks in general.

Furthermore, one should always strive to diversify. Diversification allows you to not only enjoy a wide variety of business partnerships across markets and sectors, but also diversifies your income sources. Furthermore, diversification reduces risk against business failure and permanent capital loss. Avoiding monetary loss should be your primary responsibility.

Don’t fear price changes. Volatility is opportunity, especially for those still accumulating assets. Furthermore, the focus should be on fundamentals, not price fluctuations. Pay attention to improving and deteriorating fundamentals, rather than rising and falling prices. If the fundamentals are strong and you determine a stock’s price to be lower than its intrinsic value, you shouldn’t fear buying. Consensus isn’t necessary. Be an independent thinker.

Full Disclosure: Long TGT, DLR, and PM.

How about you? Do you fear volatility? Do you think price and value are rarely correlated? 

Thanks for reading.

Photo Credit: watiporn/FreeDigitalPhotos.net

Similar Posts

95 Comments

  1. DM,

    Great article on an intereting investing topic. To me, price is simply a distraction when I am performing an analysis and I don’t include it in my stock screener. 10 shares at $100 is the same as 20 at $50, and so on. The dividend is adjusted to reflect the dollar amount of the shares anyways (And lets be honest, that’s all I really care about). The important part is performing your stock analysis using your personal metrics to determine if you are going to purchase a stock. Similar to your story with PM, I chose to re-invest in Kraft when my initial position had appreciated 20%. I re-performed the analysis and the P/E, Payout, and Dividend growth were right in the sweet spot. So why not pull the trigger even though the stock increased $15/share?

    Thanks again for the great read. Let me emphasize one line from your article in the comment section. THE FOCUS SHOULD BE ON THE FUNDAMENTALS, NOT THE PRICE.

    Bert, One of the Dividend Diplomats

  2. Hi Jason,
    very well written. I have nothing to add.
    Except for this: thanks for this long and informative article. Loved reading it and agreeing to your words.
    Best regards from Germany
    rickrack

  3. What are your thoughts on UPS? EPS took a hit due to the company reinvesting in itself so that it is completely prepared for the holiday season. Company that will surely grow with the higher consumer reliance on online shopping. They have been increasing the dividend quite often since it began trading. You can also kind of think of it as a hedge for your target investment.

  4. Dm,

    Excellent walkthrough of some very important “basics”. It took a while for me to truly look at stocks and ignoring prices whilst focusing on fundamentals. But once I did it was a relief to feel close to joy when prices went down. Because why wouldn’t I? I could now but more shares from excellent companies at a lower price.

    You’re PM example was interesting as well, since I have only invested for roughly a year I’ve yet to see the effect of improving fundamentals. But it is important to update watch lists and views on current holdings as new news come up as well as judging if some piece of news actually changes fundamentals or just a temporary fall in prices to create a buying opportunity. In the past it was hard to buy after a recent price fall but today, if I’m comfortable with the company I will buy/add.

    I do agree wholeheartedly that there is a difference between value and price. I currently use a combination of valuation formulas to give me an objective price range I’m willing to buy a stock. After a valuation I see if the company also fits my criteria for what I look for in a company I would consider owning (e.g. financial strength, dividends, growth etc.).

    Ruter

  5. Emily is quite the risk-adverse investor. It took me quite some time to convince her that a considerable gain could be had if she could be ok with having a balance that changes on a daily basis. When I first met her she was one of those people who wanted to see her savings account balance the exact same, I mean down to the penny, every time she looked at it. I explained to her that her savings account was offering a false sense of security since her purchasing power was constantly decreasing even though she’d never technically lost a penny. Now, several years later, she is quick to point out that when the share price of a stable company drops it is now “on sale.” She has finally realized that the “price is what you pay; value is what you get” line applies to investments, not just everyday purchases.

  6. Bert,

    I’m with you. Price is usually a distraction. I wish I was able to somehow find a way to completely ignore the price of a stock when analyzing it, but it’s difficult because it shows up on almost every screen right away. But analyzing and valuing a stock only to later compare it to price would be a nice way to go about it. I try to ignore the price in my head, but it’s still there.

    Thanks for stopping by. It’s definitely about fundamentals, not price. 🙂

    Cheers!

  7. Hi

    I don’t really care about the price of stock that I own as long as it is in the green or yellow zone (my evaluation system). If the stock that I own is a green after having fall by 10%, I may decide to buy some additional share, same thing if the stock increase by 10%.

    My investment strategy is to purchase the stock with the greatest value from my check list, no matter if I already get the stock. My only limitation is the percentage of a particular stock in my portfolio that need to be less than 5%.

  8. blahblah903,

    I haven’t looked at UPS in a little while. The last I looked, I thought it was a bit overvalued. But I believe it was over $100 back then. Seems to be better valued now, and the yield is a little higher. I remember not liking something else about the company, but I cannot for the life of me recall exactly what it was. Seems to be a solid pick, and you are right in that increasing online shopping bodes well for this company. I may have to take another strong look at this one now.

    Thanks for the suggestion!

    Take care.

  9. Ruter,

    I’m glad to read you’ve got a system over there that works pretty well for you and your goals. That’s what it’s all about.

    Cheaper stocks are always a wonderful gift, assuming the fundamentals remain strong. How could you not like something to be cheaper, especially if/when you were going to buy it anyway? 🙂

    You’ll start to notice improving fundamentals as your investments age a bit. And compounding will also take over. Fun stuff!!

    Thanks for adding that.

    Cheers.

  10. Jake,

    Good for you for helping her to see the folly in her ways. I was once the same, and never thought of volatility as opportunity. It really takes a mindset change to see that new perspective. But it’s a wonderful perspective once you see it. 🙂

    Tough to see inflation for what it is, and understand how it impacts purchasing power. These aren’t exactly concepts we pick up in school or something. But that’s why I’m glad to do what I do.

    Best wishes!

  11. I think price and value are usually correlated and I tend to buy stocks and then forget about what the price does. If I think a stock is a solid buy I try to take a long term view, so if it drops 10% the next day I may buy more (or not, depending on the situation). But short term price fluctuations don’t really bother me because my timeline is so long that I have the luxury of not worrying about what the stock does in the short term. Of course I would like to see long term growth and thats what I aim for when buying, but with the short term stuff I tend to tune out as needless ‘noise’.

  12. Amen. Focus on the value of the asset before worrying about the share price. I know I do that backwards from time to time but there’s still value out there. Its our brains and their horrible job with price anchoring.

  13. I actually don’t fear volatility very much, I have so much of my portfolio in growth stocks that I’m somewhat used to the fluctuations.

    I do have a hard time buying more of an investment and company that I like even when the price keeps going up. Say I bought it at $50 when it was at an all time high, then it goes to 60, then 70… Each time I look at the price I still like the company, but since I got it so much cheaper the first time it’s difficult for me to keep adding to my position. That’s the one mental block I need to get past. I think that using profits to determine value might help me with that.

  14. Dan,

    Thanks for stopping by.

    Yeah, short-term fluctuations are generally best to ignore. However, swift and significant moves to the upside or downside generally signal something afoot, and should be investigated.

    But the key is to focus on fundamentals. Focusing on price alone will likely lead to disappointment.

    Cheers!

  15. JC,

    Anchoring can get you in trouble, especially when we’re talking about an asset you already own. Makes it difficult to pay more. But as great businesses become more valuable there is an inevitability there that their stock prices will rise. Tough to pay more than you did before, but it’s oftentimes necessary when you’re investing in wonderful companies.

    Best wishes!

  16. Zee,

    Yeah, I wouldn’t focus on the price like that at all. I’d look at the underlying value of the business. If a stock climbs from $50 to $70, but the value increased by 50% then you’re better off buying at $70 then you were at $50. However, if the value isn’t there then it’s not there. At that point, you’re best just to leave be or possibly even sell if the climb was irrational and unwarranted. Tough to be an investor sometimes, but the benefits are pretty great. First world problems. 🙂

    Take care!

  17. Great post. Price really has no impact on whether you buy the stock or not. If the stock/company has values and has long term growth potentials, then it’s worth it to invest in the company. We’ve been averaging up and down on the stocks that we own in our dividend portfolio.

  18. Oh, I’m celebrating TGT’s downward going price. The company has many challenges but I think they’ll step up to the plate and deliver. Good companies like that don’t just burn down in flames out of the blue, they’ll fight hard to get back to proper form.

    I think we should start a religion around Warren Buffet, there’s nothign but good wisdom coming out of that man =).

  19. Great post! I think it really depends on your overall objective. Some people are happy with say 5-7% returns so they’re willing to pay a higher price. While others want 15-20% returns so they wait those rare bargains. With that, I think every price point is correct if it meets your overall objective. It depends on how you look at things I suppose.

  20. I do fear volatility. Too bad for me, that’s how the world is!

    I think price and general or average value are highly correlated. However, price and value to me personally are not. And one of my favorite goals of personal to finance is to capitalize on those differences.

    For example, no matter how low the price is, a stock with no dividend has either no value to you or virtually no value to you. So you don’t have to spend a single penny on those. And you don’t care about the short-term effects on some business, so you can take advantage of the price drops that result from other people caring about those. (And you diversify in case some of the effects that seem short-term turn out to be disabling.)

    And there are plenty of things besides stocks where the value to us is different than the general market value. For example, to me, a matinee movie has slightly more value than a regular movie because it is less crowded. Yet it costs less because it’s not during the traditional time of day when dates happen. So I can take advantage of that discrepancy and go only to matinees. In addition, watching a move at home has even more value to me because I can keep the volume level reasonable, turn on subtitles if I’m not understanding accents, pause to use the bathroom, etc. But because the screen is smaller and the wait is longer, the price to rent is lower.

    This method relies on being different from the average, and so it really only works if you are comfortable being different from average, otherwise you might not let yourself take advantage of those good opportunities. Since you are comfortable being a dividend growth investor rather than going for index funds or putting all your money in your mattress or living paycheck to paycheck or whatever, you can confidently take advantage of these opportunities.

  21. I used to shy away from great companies because the price of one share was “too expensive.” Completely didn’t take into account the value.

    I do monitor prices, but only to watch for pullbacks. If the price drops by 10%, I’ll take a look at the fundamentals again. If I still like what I see, then I don’t see why I shouldn’t help myself to more shares! 🙂

    Never thought about using EPS with the price/share like that. I think I’ll steal that idea from you haha.

    Thanks for another well-written article.

  22. Tawcan,

    Thanks. Glad you enjoyed it.

    And price is definitely meaningless without some kind of relative value to attach to it. $10 could be expensive and $100 could be cheap. Impossible to say without knowing exactly what you’re buying and how much it’s worth.

    Keep up the great work!

    Take care.

  23. Spoonman,

    I also believe TGT will be just fine. The data breach will be behind them here pretty soon after taking a charge last quarter. And the Canadian segment, while disappointing, is a rather small part of the business. They still have great stores that generally provides exactly what people want and need. They simply need to focus on getting the right merchandise at the right price into the hands of the right customers. And they have a lot of experience doing just that.

    And I’ll gladly go to my local Buffettism meet-up once a week. Let’s set it up! 🙂

    Best wishes.

  24. Great post as usual. To add my 2 cents, I think value is harder to determine when a person is a long term investor as we are. For example, I’ve been adding to my MCD holding recently. They are apparently being hurt by an increasing awareness of the health risks of fast food. I’m adding because–long term–MCD has had a tendency to offer new menu choices that coordinate with cultural trends but who can tell what they will be doing 20 years from now? There used to be Stewart’s Rootbeer stands all over the North East where I grew up years ago and now they’re gone.TGT has the same problem. I continue to buy on dips because they have great customer service, clean stores, and better quality products than Walmart. However, they have yet to compete with Walmart’s distribution network so they are more expensive and sell a smaller variety of items. They just didn’t catch on to the “super center” model soon enough. Even though I love shopping at TGT, they are too expensive and often don’t have what I want. I also notice that the store is usually pretty empty of customers. I hate shopping at Walmart because they are often out of things for weeks at a time, they’re employees are overworked and under paid so they are often rude and unhelpful (if you can find one when you need one), and the stores are often cluttered and dirty. However, I shop there because they are cheap and have more items under one roof than any other store. So my point is–in 20 years (our investing horizon) where will these rivals be?

    It is easier to determine current value than future value but my investing strategy depends on me buying future value. The only answer I have is diversification. What do you think?

  25. Henry,

    Hmm, I don’t know if I’d agree that “every price point is correct if it meets your overall objective”, unless someone is okay with overpaying because they’re purposely looking to lose money or not make much. In that case, then I suppose that would be correct.

    But I highly doubt there are many investors out there purposely looking to do worse than average. Many probably do worse than average, or there would be no average. But I don’t think they intend to do so.

    Although, even for someone aiming for paltry total returns they’d still want to learn how to properly value stocks to avoid losing money outright. You might be okay with 5-7% returns, but losing 20% or more routinely because you don’t know what you’re buying would obviously be disappointing to anyone.

    Thanks for stopping by!

    Cheers.

  26. Debbie M,

    Good point there.

    Price and value aren’t necessarily correlated in regards to many things in life. And there are many things that can affect value. For instance, a bottle of water might only be worth $0.05 to me because I know I can drink tap water for less than that. So I won’t pay $1.00 for a bottle of water. However, if I find myself deserted on an island somewhere that same bottle of water might be worth $100,000 all of the sudden. So circumstances, personal beliefs, and perspectives can all have substantial impacts on the value of something.

    I didn’t really go too far into that in this post because it’s easy to set up a robust system that can effectively value assets that generate cash flow. However, it’s much more difficult to value something that produces no cash flow, as it’s then simply left to what someone is willing to pay for it. That’s why gold is nearly impossible to value accurately.

    Thanks for adding that!

    Best regards.

  27. Seraph,

    To the uninitiated, absolute stock prices might be all you look at. So a $100 stock is expensive and a $10 stock is cheap. I hope anyone just starting out is reading this and learns that there’s a lot more to it than that. 🙂

    And I watch prices in a similar manner. If I valued a stock at $60, bought at $55, and see it drop to $50, you can bet I’m already brushing up on the company’s fundamentals and looking to buy more!

    Thanks for stopping by.

    Take care!

  28. Steve,

    Well, nobody can predict the future, my friend.

    However, I disagree that valuing a stock is a more difficult task for long-term investors. I actually think it’s easier. If you’re investing in solid businesses, the stock price fluctuations will be lost over the course of 10, 20, or 30 years. Buying KO at $42 or $39 won’t make a huge difference if the stock is trading for $100 a decade or so from now. However, it might make a difference when looking at where the stock is at six months from now. Time is the friend of both wonderful businesses and the long-term investor, and can heal initial valuation boo-boos.

    As far as your TGT/WMT quandary, these may not be good investments for you. Every business has risks, and every investment is a bet to some degree. You have to ask yourself if the risk makes sense for you. If it doesn’t, the good news is that there are hundreds of other companies out there you can invest in. However, I would caution against judging a $250 billion (WMT) company on your personal experience with a local store. Look at the numbers. Are people shopping there? What is the top line and bottom line growth like? What are they doing to keep up with competition? As far as TGT not catching on the supercenter model, that’s okay because WMT is moving away from that into smaller stores, like Target is doing with CityTarget.

    Retail is probably one of the riskier plays out there because the landscape is changing quite rapidly. If these investments do not make sense for you, I would recommend finding some that do. Don’t talk yourself into an investment. But don’t talk yourself out of one based on your personal experience when you have to consider millions or billions of customers across the world, especially if the fundamentals are solid.

    Best wishes!

  29. hemgi,

    Sounds like a good system there. As long as the stock is in your buy zone you buy, regardless of whether the stock has gone up or down. Separating price and value is extremely important, and refusing to buy more equity in a great business because it has appreciated from when you bought it will limit your chances at increasing positions in great businesses. Great businesses should and most likely will appreciate over time. To expect them to stay cheap forever would be unrealistic. Strike while the iron is hot. 🙂

    Take care.

  30. Jason,

    I found this very informative and timely for my small portfolio. I’m always stuck figuring out whether to add to a current position that’s down or to diversify first. I’m definitely focusing on valuation, and want to average down when positions go in the red, but my weights are so fickle with such small amounts it makes me a little indecisive. I’m eagerly wanting a bigger portfolio and still have a lot of work to do. Really great article!

    All my best,
    Ryan

  31. Excellent post.

    For me the really key to successful investing is understanding this dislocation between price and value.

    I was trying to convince a good friend of mine to stop being so hung up on prices the other day!

  32. Jason,

    you value shares with DDM.

    Have you ever thought about the following model?
    I want back my purchase price in form of dividends in x years. Taking into account the dividend growth.

    Ahoj,
    ZaVodou

  33. Very nice Jason! Yea if the price of a stock was all that matters everyone would be buying penny stocks and no one would desire Berkshire Hathaway (as the extreme examples). It is important to look at numerous factors of the company including revenue and earnings growth, debt, price to earnings, dividends, among other things. I am still working on my analysis but I don’t just look at the price or P/E ratio to determine if I should make the purchase.

  34. DM,
    I don’t look at the price when I analyze. Like you said the other metrics provide more valuable insight into the company. Also, thank you for the links to how you analyze. I had been curious for some time now on that dividend discount model you refer to.
    DFG

  35. Nice article DM focusing on the fundamentals. Sometimes people get lost due to information overload and they lose track of some of the basic concepts… An article like this helps to get one’s focus back 🙂

    The example of PM was good and helps communicate the difference between price and value. Being invested for long term, I always look for a “sale” in the market. An example would be my new position in BP last week when it dropped close to 5%. I could be wrong in getting a company that might have so many legal issues coming up, but I think in the long run, BP should be able to ride it out… And the world will definitely need its oil for years to come 🙂

    DGJ

  36. Hi DM,

    Thanks for the insight, it goes a long way to discuss how much value a company has vs. its price.
    I recently sold off a real estate investment trust Riocan (REI.UN.TO), not because they were faltering or missing dividends. They are actually a very stable and growing business.
    They simply do not grow their dividends with any regularity. Nice yield at 5.2%, but they continue to issue shares and haven’t raised dividend payments much over the last 7 years. Therefore the stock does not have forward moving VALUE.
    I sold them and purchased Suncor Energy (SU.TO or SU.NYSE) Much better dividend growth prospects, solid core fundamentals and our good friend Warren Buffet continues to add to his position and owns about 1.6 million shares (approx. $650 million) of Suncor.
    Easy to do when Suncor CEO Steve Williams came from Exxon Mobil, another core Buffet holding.

  37. Excellent article Jason!

    This is exactly what I’ve tried to explain to my dad who is just starting investing. I have to send him a link or translate this into Finnish – maybe he’ll get it when someone else explains it :).

    It is hard for a lot of people to understand the upside in declining prices on stocks you own and it’s also difficult to buy a stock when it was cheaper the last time a purchase was made. Your article explains it almost perfectly and I especially liked the example on PM.

    -Ville

  38. DM,

    Exactly, we’re finally seeing some good value in this market. CVX,MCD, look to be some examples of your article.

    Keep up the good work!

  39. Ryan,

    I wouldn’t worry about the weighting too much right now because that’s rapidly changing with every single subsequent stock purchase. Those weighting changes will slow down a bit as it grows and then you can be a bit more deliberate. I’m not saying to not diversify, but rather to focus on the overall portfolio construction for the long term rather than individual weighting changes right now.

    But you’re doing great. 🙂

    Take care.

  40. UTMT,

    Thanks!

    There is almost always a spread between price and value, and successful investors are good at using that spread to build long-term wealth. Focusing on quality, diversification, and a lengthy holding period smooths the volatility out and limits losses.

    Cheers!

  41. ZaVodou,

    I wouldn’t use that to value shares because the DDM analysis is assuming constant growth. I don’t know how you’d factor that in where you’re looking for your capital back in a certain number of years. But it’s really along the same lines as investing in great businesses that pay rising dividends will ensure you get all of your capital back and then some anyhow. The DDM analysis is simply projecting dividend growth out over many years and then discounting that back to a current rate to give you fair value, similarly to a DCF analysis.

    But I anticipate many/most of my investments will eventually completely pay me back. Every dividend is a payback of sorts, and a reduction of the capital I have at risk. 🙂

    Cheers!

  42. Kipp,

    Absolutely. It’s a lot more than looking at the price of something. This might seem easy to those who have been at it a little while, but those just starting out are coming from a consumer mindset where “less is better”. A cheaper priced stock isn’t always a better stock, and won’t necessarily save you any money…unlike how a cheaper pair of socks will probably save you money over a more expensive pair of socks, all else being equal.

    Good luck coming up with a system that works well for you. 🙂

    Take care.

  43. DFG,

    Glad I could help! I think Matt’s spreadsheet is really nice and easy to use. Though, it’s not totally necessary if you’re familiar with the math behind the DFG or GGM. But it’s quick and easy, which I love! 🙂

    And definitely – price will only tell you what you’re paying for something. You need to know what you’re getting for that money, and that’s where everything else comes into play.

    Thanks for stopping by!

    Cheers.

  44. DM,

    Very good post and I enjoyed reading it. I especially liked the part about averaging ‘up’ so to speak. You don’t often hear about it, in compatsion to averaging down. I agree with you, because if you believe the company is worth owning after your valuation, it doesn’t really matter if the stock is on a dip etc. for the long term. I will say its hard to pull the trigger at a higher price tag, if you bought it lower recently. I did it with AAPL last week, as I believe the company is attractively valued and has huge potential to raise dividends significantly.

  45. DGJ,

    Yeah, paying more or less for a stock really doesn’t tell you much. I often hear of investors talk about pullbacks, but they don’t associate that with any underlying fundamental value. So to expound on anxiously awaiting a stock to fall from $80 to $75 without really knowing whether $75 is a good deal or not would really be a waste. Furthermore, if that particular stock is worth $100, then you should be trying to find stuff in your attic to sell so that you can raise capital to buy it immediately, rather than wait until $75 (which may never come). 🙂

    Thanks for stopping by!

    Best regards.

  46. Zol,

    Thanks for thinking of me! 🙂

    Too late for me to participate in something like that now, but maybe I’ll keep an eye out for it next year. I’m still trying to pin down time to get started on a book. I have so many ideas for it, but it’s tough to set aside the resources to get the ball rolling.

    Cheers!

  47. Duane,

    I don’t know anything about Riocan, but it sounds like you did your homework. The key with unloading a holding like that is just to move on. I may track an old holding to see if it’s worthy of investment at a later date, but I emotionally move on.

    I like SU. It’s actually on my watch list. So many stocks, so little capital. I have about 30 stocks on my watch list right now that I don’t own, so it’s tough to find the capital and room for them. Seems like a reasonable and well-thought choice.

    Best of luck with the new investment! 🙂

    Take care.

  48. Ville,

    Thank you! Glad you enjoyed it. 🙂

    These are difficult concepts, especially for those just starting out. But I even sometimes see veteran investors stumble when prices radically change. They anchor to a price and get their heads wrapped around the fact that the value may have changed.

    I hope your friend is able to read it and get some value from it.

    Best wishes!

  49. Hi Dm,

    Great write up. I enjoyed reading this article. To bad many people don’t seem to grasp this.
    My heart is full of joy when I see a falling stockprice on my watchlist ( as long there are no fundamental changes).

    Cheers,
    G

  50. Agent Dividend,

    Yeah, averaging up is oftentimes necessary if you’re investing for longer periods. After all, you can’t explain shares on companies like KO, PM, JNJ, and the like to stay the same for decades. Unless, of course, they were just irrationally overvalued from the start, in which case my whole point on value becomes prescient. 🙂

    Thanks for stopping by.

    Cheers!

  51. Geblin,

    I’m with you. My heart flutters just a little bit when I see Mr. Market irrationally discounting a stock, creating a huge opportunity for me to buy in well under fair value. Just one of the many pleasures of being an investor. 🙂

    Thanks for the compliment. Glad you enjoyed the post. I put a lot of thought behind it.

    Best wishes.

  52. Jason,

    I admire your skill for writing hundreds of words and still saying NOTHING at all. that investors do not look at the price itself is a nobrainer. diversification? really, that ultra new.
    unbelieveable skill, you become politician!

  53. Jeff,

    This was a worthless and disappointing comment on so many levels. How can you claim to know what all investors know, don’t know, and need help understanding? Even though someone worked hard to provide content for free, you’d rather be a troll and spew venom while hiding behind your keyboard than simply stop reading and move on. You’re a real shame as a human regarding respect and maturity and I hope to never have to read anything you write on here again.

    ~Ryan

  54. Wow great post Jason! This answers my question from your previous post in regards to a stock climbing on price. This is one of my favorite post and worth bookmarked and a read over and over. Congratulations on your Plutus Finalist Award, your hardworking is paying off, you deserve it!
    Christian

  55. Dividend Harvester,

    Haha!

    I’d like to think Buffett would want us to come as we are. As I understand it, he’s quite a fan of sweats when he’s not in a suit. Maybe that would be the official “hat”. 🙂

    Cheers.

  56. Christian,

    Exactly. I had this post drafted out a bit, but your question the other day motivated me to finish this up and get it out there. I can’t remember ever addressing price and value like this, and averaging up vs. averaging down.

    Glad you enjoyed it and found some value in it! 🙂

    Appreciate the support very much. Thanks for stopping by!

    Best wishes.

  57. just a question for your opinion i have about 7k in stocks such as IWO,IWS,HYG,VNQ etc im 22 and actually have moved away from there and started monthly putting into companys similar to yourself i see buffet also stays away fro etfs etc like these did i make a bad move im deff focosed on DGI .. can you kind of break it down for me why one is better than the other investmenty style

  58. Alex,

    There’s nothing inherently wrong with investing in funds, but I would recommend keeping it simple and sticking to an S&P 500 index fund, or a total market fund.

    That being said, I’ve already discussed why I prefer investing in individual dividend growth stocks:

    https://www.dividendmantra.com/2013/04/why-i-vastly-prefer-dividend-growth/

    Index investing is best for those that lack the time and/or inclination to invest in individual stocks. It can be time consuming on the front end before the dividend income is paying for your lifestyle; however, I find it quite enjoyable and fun. I look at it like a hobby that just so happens to pay pretty well. You, however, might not enjoy it at all.

    It’s best to find a strategy that best suits YOU rather than listen to everyone else. 🙂

    Best of luck!

    Cheers.

  59. Thank you for the quick reply and of course I love researching and managing my stocks as well thank you for the quick reply will keep in touch !

  60. Thank you for your thoughts, Jason.

    I asked because I read that some super investors want have their money back after seven years or even earlier. Not by dividendends, but by earnings.
    I wanted to pick up on this idea and apply it to dividend investing. Easy to handle with excel and no discount rate required.

    Ahoj,
    ZaVodou

  61. What a wonderful explanation of a classic concept. And made even better with great use of your real life examples to bring it to life.

    Really glad you made the point about not loading up on one stock, and the importance of diversifying. I made my biggest investment mistake by going all in on a stock I was certain was significantly undervalued. I created all sorts of models, looked at value from a range of perspectives (P/E, Price / book value, DCF), even went as far as doing some rough valuations of their ‘intangible assets’ (they had some pretty significant long-term contracts that were a key asset). Everything pointed to it being significantly undervalued. So I loaded up. And of course, a highly dilutive capital raising shortly followed – turned out their debt level was a bigger issue than expected…

    You can fall into the trap of believing greater valuation complexity = more accuracy, but it just isn’t true – there is a great deal of art and experience involved as you mentioned. And there is always some level of uncertainty or risk involved, no matter how (over)confident you are!

  62. If an investor doesn’t know to not only look the price, he’s no “Investor” but a dummy.
    Wish you luck, kiddos.

  63. Agreed on your last line about fundamentals being more important than price. Sometimes the real challenge is realizing, that when you are buying a stock, the person on the other side of a trade has access to the same information you have, yet he wants to sell that particular equity. You don’t know why he/she wants to sell it. Possibly taking a profit or possibly he sees something fundamentally wrong with the business, yet as a buyer, we think we have done our homework and are excited to buy what he doesn’t want anymore. Even Warren Buffett has admitted he has made some incredible mistakes on businesses such as US Air, Conoco Phillips & even buying Berkshire Hathaway itself.

  64. Interesting discussion on Target, and would like to pose a question. As you mentioned in your post, Target has had problems with data breach as well as Canadian operations. Add to that the overall sector problems of competing with online shopping and going head to head with the largest retailer in the world ( Walmart). My question would be what is the catalyst to show you Target is forging ahead and not going the way of Sears ( for example) Would it be 3 or 4 quarters of positive or negative earnings growth or possibly a couple large dividend increases or cuts?

  65. Excellent point about funds if you don’t have the time or inclination to research individual stocks. I read where Buffett has instructed his executor to put the his money left for his wife ( after his charitable donations) in 90% S&P 500 and 10% short term bonds

  66. I happen to have a post on the exact same topic and i must say that this is a great post you have written and definitely better than mine. Beneficial. 🙂

  67. Really intriguing stuff, Jason. I go back and forth on the efficient market theory. I generally believe stock prices are fairly efficient, but can appreciate that there’s just no way they can be perfectly so. And I think that for the buy and hold investor who is buying an equity regularly, there’s no denying that buying the same company at a lower price today than he purchased it at twelve months ago provides good value (everything else being equal).

  68. ZaVodou,

    That doesn’t sound like a bad way to go about it. I don’t know if I’d use a formula like that to value a stock, as you’re simply trying to predict a payback period. But it certainly is quite reassuring to see that you might have all of your money back in X years. 🙂

    Cheers!

  69. Jason,

    Yeah, I can imagine overconfidence has ruined more than one investor out there.

    I could have bought even more PM early on, or when they dropped down from ~$90 to the mid $70s. But what if smoking rates decline faster than what is anticipated? What if they roll out bad e-cig products and they start to lose new customers? What if plain packaging spreads across the world?

    Investors always have to take risks very seriously. Stocks are wonderful, and I think they’re by far the best asset class out there. But to blindly buy, buy, buy without assuming all of the risks and hedging against that risk would be a big and potentially very costly mistake.

    Thanks for adding that. Terribly sorry you had a bad experience there. Never fun to lose money or realize you weren’t correct. But it’s a great lesson to learn early on so as not to be repeated.

    Best wishes!

  70. Brian,

    Mistakes will definitely be made. Nobody is perfect.

    I try to approach every transaction with a humble nature, and with an open mind. My entire thesis could be incorrect, or the growth might not pan out. Therefore, I might lose money. But that’s why I try to diversify and ensure a margin of safety. Limiting risk is something I aim to do every day.

    One man’s trash can be another’s treasure. But sometimes trash is just trash. Recognizing the difference can be difficult sometimes, but I think when we’re talking about high-quality companies, your odds of encountering trash very often is pretty low.

    Best regards!

  71. Brian,

    That’s a good question.

    I don’t know if I’d rely on the dividend raises alone, as their most recent dividend increase would give one a lot of confidence. But I think they were actually a bit too aggressive there, especially with all of the issues they have going on right now. I could be wrong.

    The last quarter was impacted negatively by the breach, and management has indicated that most of the charges as they see it should be accounted for. So I would hope to see EPS moving in the right direction from here. 2014 should be a low point. And I would hope to see both revenue and EPS moving up. FY 2015 is already showing improvement. However, if FY 2016 is much the same, or appears to be going that way, I might have to revisit my thesis here.

    Their growth up until the breach and Canadian expansion was astounding. So it’s not like we have a slow, steady decline of a giant (like Sears). Rather, the business hit a major bump in the road. Whether or not they recover will show up in their financial results over the next year or so. FY 2015 is already halfway over. I hope to see EPS over and above what we saw for 2014, which will be determined by their 4th quarter. 2016, in my opinion, will be the year where TGT shows whether or not it is turning around. And at the end of FY 2016 I’ll have to see if the catalyst is there. S&P Capital IQ predicts EPS of $4.00, and I’d be happy with that.

    Best wishes!

  72. On the topic of price and value, what are your thoughts on GSK? It looks like a good value but is the price still a little to high given their issues?

    You’re the man Jason, but you know that already.

    Frank

  73. DB40,

    I investigated the EMH very early on when I was initially putting my investing strategy together. To me, it just didn’t make any sense at all. I couldn’t rationalize EMH and large cap companies swinging by 1-2% on a daily basis with no new information. And then you have a group of investors that were able to do quite well over decades, and the whole idea became nonsensical to me. But that’s just my $0.02 on it. 🙂

    I agree, though. If the fundamentals remain the same, or improve, and the stock is priced less than what you valued and bought it at, then I don’t see how you go wrong there.

    Thanks for stopping by!

    Cheers.

  74. True. Also when you’re richer you’re willing (and able) to pay more for things.

    But this post is about things with cash flow. Suddenly I’m thinking of other things with cash-flow-like qualities, like tools that let you do things yourself instead of hiring someone. Many of these are hard to do math about, too. Well, it might be easy for oil-changing tools or something else with a predictable, periodic cost/savings.

  75. Do you keep track of the amount of money you have actually invested in the stock market as opposed to how much the Freedom fund is worth? I see that the fund is worth about 171k now, but how much money have you actually you put in? I would be interested in seeing the rate of return overall (including and excluding dividends).

    Thanks for the interesting articles.

    Jashwant

  76. Jashwant,

    Your question begs me to wonder if you really understand the benefits of rising dividend income and the whole point behind this strategy. However, in the interest of full disclosure I don’t mind sharing. I’ve contributed approximately $112k of my own capital to date. You can view all of my dividend income since the inception of my account here:

    https://www.dividendmantra.com/dividend-income/

    The rest would obviously be capital gains. 🙂

    Cheers!

  77. Thanks for the reply. I understand that you are primarily looking for dividend income, but i thought it would be interesting to look at capital gains as well. I have read that dividend stocks provide better returns compared to the rest, so i was curious. Also, i wanted to compare how much money i managed to save compared to you. I hope to save at least as much as you in 4yrs.

    Thanks

  78. Jashwant,

    No problem at all. Glad I could help.

    If you can focus on saving a high percentage of your income and invest in high-quality assets that generate rising income, you’ll very likely surprise yourself as far as how much you can accomplish in a short period of time. 🙂

    Best of luck!

    Cheers.

  79. Very informative post Jason. I knew there was a lot that goes into selecting the appropriate stocks for your portfolio, but there is one constant I’ve noticed, and that is diversification is key. Even if you pick the best stocks over a period of few years, if you don’t diversify your holdings you will face a big downturn at some point. It seems the name of the game is minimizing risk while maximizing value.

  80. Syed,

    Absolutely. I view diversification as the moat between my castle (freedom) and the outside world (a job). The larger the moat, the less likely marauders are going to storm my castle and demand a resume. Diversification not only minimizes the potential of capital loss (my #1 priority as an investor), but also income loss. Income loss of a percentage point or two in early retirement probably won’t matter, but losing 10% or so of your income would most likely be a problem.

    I could do all the homework on a company and feel great about investing in them. But that’s not to say they won’t perform as expected or larger forces at play won’t make it a bad investment. Therefore, I diversify to prevent such problems causing major drains on my wealth. We’re all wrong from time to time. But being wrong in a ruinous way would be a real tragedy. I’d rather be wrong in a “I was wrong. Oh, well.” type of way.

    Cheers!

  81. I’m still fairly new with my investing and am slowly getting round to the idea that prices dropping mean ‘opportunity’.

    It’s hard to look at negative figures and feel good about them but I’m trying!

  82. weenie,

    I know how you feel. It doesn’t come naturally. I felt it pretty early on, but it takes time to get used to it. 🙂

    You’ll get there. And if not, that’s okay too. Just try to buy quality, remember that time in is better than timing, and ignore the noise!

    Thanks for stopping by.

    Take care!

  83. “How about you? Do you fear volatility? Do you think price and value are rarely correlated? ”
    As a value investor and long term dividend investor I don’t fear volatility, which is anyway part of the stock markets. And price vs value, depends of course of the company, but in these pumped markets a large portion of stocks are overvalued and another one fairly valued. The undervalued part is the difficult one to find, but it is nothing new since that’s not the first time that the markets are high. So rarely or not depends more at which time frame we consider a given company.

  84. farcodev,

    Volatility is always part of the stock market. We see that every day. But where some people fear it, I embrace it.

    I agree that a large portion of stocks are overvalued right now, but I continue to make equity purchases month after month. Some of these purchases involve me paying pretty close to fair value, and some seem to suggest I’m still getting a fairly good deal. Time will tell. 🙂

    Cheers!

Leave a Reply