Price and Value

Last night on a boozy zoom call with some friends I did a very poor job of trying to explain how I think about the difference between price and value (and why that difference is important). I’m going to try to use this space to clarify my thoughts on the subject in a way which will hopefully be informative to y’all as well.

I believe that the term “value” can apply to a few distinct concepts:

  • Usage value — this is something like the “utility” that I get from usingĀ  a product or a service
  • Financial value — this is the purely monetary value of an asset and generally refers to future expected income streams from owning an asset

The consumption of consumer goods often only have usage value — for example, buying a ticket to go see a movie has no financial value because there’s no future expected returns from that. Owning a financial instrument, like a stock or a bond, often only has financial value in that there’s no additional utility that comes from owning that asset. Something like owning a home has both — both usage value (if you live in that home) and some amount of financial value from a potential future sale of that home or from renting the home out to others.

The financial value of an asset can be tricky to reason about because there are a few different interlocking concepts:

  • Financial value
    • True future income stream — this is the “true” schedule of future returns from owning the asset. This is unknowable except in retrospect.
    • An individual’s fundamental valuation — this is the net present value of the assets future expected returns.
      • An individual’s belief’s about the future income stream of an asset (i.e., what’s going to happen in the future)
      • An individual’s net present value function which will vary depending upon the individual’s belief’s about the future and their risk tolerance (the value of money today vs money tomorrow)

I want to say that there exists a true future income stream of an asset that exists but that it is unknowable, and lots of different individual’s fundamental valuations. Individual’s valuations may differ because they have different beliefs about the future or because they have different discount rates.

One thing that complicates this picture is that to any given individual, there are two different ways that an owner can realize the value of an asset:

  • Receiving a stream of income into the future according to the assets true future income stream
  • Selling the asset to someone else at the prevailing price

The second point is what can lead to confusion about what the value of a financial asset is — since owners of an asset can always sell the asset at the prevailing price, it can be tempting to say that the price reflects the asset’s value.

When I’m talking about financial assets, I want to define price and value distinctly.

  • Price: in financial markets, price reflects the weighted average beliefs of all the individuals in the market about the financial value of the asset

So, price does not impact the financial value of an asset in terms of future income streams, but it can affect the value to an owner of the asset, because if the price is higher than the owner’s individual fundamental valuation, they can (and should!) sell the asset on the market and come out on top.

The point that I want to keep clear is that the price of an asset can move around a lot (e.g., in the stock market) without the underlying value of the asset shifting at all — sometimes they both move together, sometimes the value can change while the price stays the same. But they’re too distinct concepts and hopefully this clarifies how they’re distinct.

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By michael