Finance

The Most Critical Distinction All Investors Need to Know (Price vs Value)

It’s easy to confuse the price of an asset with its value. Unfortunately, this confusion can lead to dramatic financial loss, and even determines the winners and losers in financial transactions. Here’s how to tell the difference…

The Most Critical Distinction All Investors Need To Know (Price vs Value)

From Peter Reagan at Birch Gold Group

Economic principles like price and value are important to understand, because they are used when buying and selling almost everything.

But they are different principles, and at least one difference between the two can be summarized by a quote from Warren Buffett, the Oracle of Omaha:

"Price is what you pay; value is what you get."

As simple as this sounds, price and value still get confused. Today we’re going to explore this idea.

More key differences between price and value are summarized below:

Price: Price is the amount paid for acquiring any product or service. Price is ascertained from the customer's or marketer's perspective. Prices of products and services increase or decrease.

Value: Value is the utility of a good or service for a customer. Value is ascertained from the consumer's perspective. Value remains unchanged, i.e. a house provides you a place to live. That said, the price a person puts on this intrinsic value does change.

You can also think about the two principles this way: Price is measured by money. Value is measured by utility, or usefulness.

Price is objective. Prices are usually set by markets, and may or may not reflect the value of an asset.

Value is subjective. An asset’s value often plays a role in establishing its price (we’re usually willing to pay more for higher-quality, useful assets) – but value is not the sole determining factor in establishing prices.

As simple as these concepts are, you’ll discover that what happens in the real world is a lot less simple. Some people are still confused by the actual differences between the two terms.

With that in mind, let’s take a moment to dive into a few real-world situations where these two principles are important.

Three examples of the price vs. value mismatch

That new-car smell

At some point in life, the decision to buy a car arises. Initially, it might be tempting to buy a brand-new, factory-fresh vehicle instead of a used one.

Just how much are you willing to pay for that new-car smell? Because it might cost a lot more than you think…

The moment you drive a new car off the lot, according to Dave Ramsey, its value drops significantly:

A brand-new car loses somewhere between 9–11% of its value the moment you drive off the lot. So, with a $30,000 new vehicle, you’re basically throwing $3,000 out the car window as you drive the car home for the first time!

After only five years, that shiny new car typically loses 60% of its value. That’s called depreciation, and there are established accounting formulas used to determine the exact value of an asset based on its history.

Choosing to buy a “reliable, slightly used car” instead, you let someone else bear the brunt of a new car’s rapid depreciation and ideally save money at the same time.

Now, let’s move from the world of tangible assets into a more speculative marketplace…

The non-fungible token boom

The best real-world example of the difference between price and value comes from the crypto world. Non-fungible tokens (NFTs) took the world by storm over the last few years.

For a while, they were incredibly popular. In April 2021, Yuga Labs launched the most famous NFT collection, the Bored Ape Yacht Club, with 10,000 unique NFTs. They were originally priced at about $190 and sold out within 12 hours. One year later, the average price of each NFT had risen to $430,000.

You might wonder what a buyer received in exchange for that $430,000? The answer is something like this:

Example of a bored ape yacht club NFT

Please understand, this is not a joke. (Not to the buyers, at least.)

A survey of NFT owners reveals the intention behind the majority of purchases:

The second most-common reason, “Community and flex,” is a euphemism for conspicuous consumption. Just like some people are willing to pay tens of thousands of dollars to join a country club – so they can hang out with country club members, and brag about their country club membership. Community and flex.

Digital art collectors presumably receive some value in the form of the joy they feel when contemplating their NFT. That joy may be real – who am I to deny it? But it’s a non-financial value, difficult to price.

I really can’t speak to the value represented by those who bought an NFT to access games and tools.

Value, as we’ve established, is subjective. Price is not. So imagine how those who spent $430,000 for their NFT felt when they saw this recent study:

…95% of the collections of non-fungible tokens are worthless as the market for digital art has collapsed.

“Worthless” means, in this context, a price of $0.

But even that’s difficult to establish because the overall NFT market isn’t particularly liquid:

The study said 79% of those collections remain unsold, meaning the market is oversaturated with sellers while potential buyers are being more discerning than ever in what they purchase.

Why do those collections remain unsold? Because their price doesn’t accurately reflect their value.

What about the most discerning of purchasers, who only buy the highest-quality NFTs? Well, the same study told us that 18% of the “top collections” were worth $0.

Among the top 8,850 NFT collections identified by CoinMarketCap, the study found 1,614 had zero value.

Now, this doesn’t mean there’s no profit to be had in this market. Those speculators who were able to score a $190 NFT may very well be ahead, if they can sell it.

Those unfortunates who paid $430,000 on the other hand? In the hope of making money? Their speculation was based on what investing legend Benjamin Graham called, in his masterwork The Intelligent Investor, the “greater fool” theory:

The greater fool theory states that it's possible to make money by buying assets, not because they are undervalued, but simply because there is someone else who is even more optimistic and willing to pay a higher price.

When price greatly exceeds value, the only hope is that a “greater fool” is willing to pay more than you did. In this theory, it’s easy to see that the greatest fool suffers the greatest financial loss.

Today’s housing market

The last example that illustrates the key differences between price and value is the current housing market.

Wolf Richter wrote about this recently. Asking prices don’t appear to be matching up with reality:

Homebuilders are trying all kinds of stuff to get sales going in this environment of 7%-plus mortgage rates, including cutting prices, building at lower price points, piling on incentives (such as free upgrades), and the biggie, buying down mortgage rates, which can get expensive for builders.

Neither incentives nor mortgage-rate buydowns are reflected in the prices of homes sold, and yet prices have dropped, and sales have dropped too below 2019 levels, and inventory increased, and months supply jumped. For homebuilders, who cannot sit out this market because their business is to build and sell homes no matter what the market does, it’s not an easy environment.

Furthermore, homeowners interested in selling are pricing their “used” homes too high. That’s an easy mistake to make! After all, when you spend years living in a home, there’s a ton of sentimental value attached. (Your children’s heights are penciled on a door frame – how can you set a price on that?) The technical name is the endowment effect, and it’s been studied.

Regardless, the way this manifests is that homeowners want to be paid more for their homes than the market thinks they’re worth. The price and the value are too far apart.

Meanwhile homebuilders are still building new homes they’re struggling to sell, even with massive incentives for buyers.

This means big trouble in the housing market.

Eventually, the market will reach an equilibrium – but that might take years.

With these three cautionary tales in mind, how can we ensure that we’re receiving value commensurate with the price we pay for an asset?

Picking winners and losers

This article from PwC gives us a major clue:

“buy low, sell high” therefore requires a benchmark value – e.g., a low price relative to what value? Buyers and sellers need to focus on the gap between market price and intrinsic value, because that gap may decide the ultimate winners and losers in a given transaction. [emphasis added]

In simple terms, make sure the price you’re buying at is consistent with the value of what you’re buying.

That “benchmark value” mentioned above could come from anywhere. I think it’s smart to look to history to establish benchmark value.

Take physical gold and silver, for example. Both have been assets both priced and valued throughout human history. Precious metals are some of the very few financial assets you can hold in your hand. They’ve held their value relative to currencies and other assets for thousands of years. Precious metals have intrinsic utility for industry and as a form of money. As Ben Shapiro says, precious metals are “the one area of human activity that has never been worth zero.” (Unlike NFTs.)

Gold especially has intrinsic value proven relatively constant over centuries, regardless of price. Both gold and silver are recognized as a store of value. To give you more food for thought, we’ve also developed a free kit, packed with information that explains in clear terms (with charts!) why both gold and silver could be good options to consider right now.

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