****A good value is something you can buy for less than it is actually worth.

 

A good value is something you can buy for less than it is actually worth. While that shouldn’t be possible in the theoretical world of “rational” investors, recent experience suggests investors aren’t always rational. They sometimes overpay for a stock (recall any one of the many tragic Internet or tech stories), and sometimes don’t understand value when they see it. (Vincent van Gogh couldn’t sell his work during his lifetime.)

 

Then, how can an investor assess the relative merits of the candidates on his or her list?

A good place to start is to remember that each share of stock represents ownership of a piece of a business. This suggests that two things should be very important to a stock buyer:

 

• How good is the business I am buying?
• How big a piece do I get for my money?

 

To make the point, imagine you’ve been offered a chance to buy into an ideal vacation property in a great location with all the amenities you could ask for. Although you couldn’t afford this on your own, by sharing the cost and use with others, the price comes to about your annual vacation budget. It looks like the perfect investment for you until you find out that, because of the number of total partners, your turn amounts to 1 hour and 20 minutes every March 6 from 3 to 4.20 a.m.! This otherwise great buy is a terrible deal because it costs too much for the piece you’re getting.

 

Many stock “values” have the same kind of problem. If a stock costs just $5 per share, but you’re only getting a penny’s worth of profit value, it’s not a good deal - even if the business is thriving.

 

One measure investors use in their search for value is a stock’s price relative to its 52-week high and low. The thinking is that a stock that traded at $70 per share at its 52-week high and now trades at just $40 per share at or near its 52-week low is a value. While this may be a useful flag for identifying possible values, it could have some serious drawbacks if used alone in your security selection. The stock may cost less today because:

• it’s actually worth less, or
• maybe it was never really worth $70 in the first place, and investors are finally waking up to that fact.