Leave it to Warren Buffett to sum up the dilemma in a single pithy dichotomy.
The world's greatest investor reminds us that the value of an asset -- whether a car, a house, or a stock -- does not necessarily have any relation to the price we pay to own it.
Buffett's observation still leaves us with one crucial question: How exactly do we know the value of the asset?
- Benjamin Graham's classic non-answer stated that an asset is worth at least its book value, so you're safe if you pay less than that.
- There's also a logically impeccable but not very helpful adage that "an asset is worth whatever someone will pay for it."
- And Professor Aswath Damodaran offers this math-intensive solution: "The value of equity is obtained by discounting expected [residual] cash flows."
A more honest answer, though, is that we simply never know how much anything is worth. Not exactly, at least.
Yet in real life, we don't allow the lack of an exact answer to stop us from buying.
- Humans need shelter, so we buy a house when the price seems fair.
- We need cars, so we work from sticker prices and the Kelly Blue Book to pick an acceptable price for those, too.
The same goes for stocks. We shouldn't "measure with a micrometer, mark it off with chalk, then cut it with an axe."
- We make our best guess at a fair price (intrinsic value).
- We try to buy for significantly less (margin of safety) than our estimation.
Start with common sense
Look in places where you're more likely than not to find bargains:
Low prices: Stocks hitting the new 52-week-lows list may be "down for a reason." Still, a stock selling cheaper today than it's sold any time for the past year is more likely a good bargain than a stock selling for more than it's ever fetched before.
Read the paper: Newspaper headlines offer another superb place to seek bargains. Remember how oil was selling for $150 a barrel last July? Remember how a few months later, it sold for less than $40? How much do you want to bet that the intrinsic values of oil majors such as ExxonMobil (NYSE: XOM) or Chevron (NYSE: CVX) tracked those movements exactly? (Hint: They didn't.) Somewhere between $40 and $150, there was value to be had in the oil majors.
Cheap valuations: Another great way to scan for bargains is to run a stock screener every once in a while. I like to look for stocks that trade for low price-to-free cash flow multiples, exhibit strong growth, and have low debt.
The key point I want you to take away from all this is simple: Trust your instincts.
- When Zillow tells you your house has doubled in value, treat that "Zestimate" with some skepticism.
- When Suntech Power (NYSE: STP) doubles in price on announcements of industry subsidies from China, be wary.
- On the other hand, when stocks that have little to do with the financial crisis drop 50% in the space of a year, when stock prices don't match the news they're supposed to reflect, or when you stumble across a stock with a price that looks cheap, you might just have found a bargain.