Last year, I shared with readers a tale of woe regarding my being a lowly buyer in a white-hot Washington, D.C., real estate market. I did a follow-up piece about six months later to respond to the influx of email that I received from readers who wanted to know whether my wife and I ever chose to bite the doormat and hop into the bidding wars (we didn't).
In that second article, I had this to say about extreme home valuations:
In this "high-bidder" market, many have assumed that the price they're paying is what the home is actually worth. "Besides, someone else will just come along and snatch it up if we try to deal," they say. In this market, that's largely been true, but the problem is that someone else will only come along and snatch it up until there is no someone else.
And when that happens, prices aren't going to be so frothy anymore. Sticker price will be an exception again, as opposed to a rule, and gone will be the days of bidding $20,000, $40,000, or even $60,000 over what the seller is asking.
In the case of those folks who paid $60,000 more than the home is worth just to beat out competitors, what happens when there are no competitors? I'll give you a hint: The house starts selling for what it's actually worth again, and that means someone just lost 60,000 bucks in value.
The debate
Now, some of the more interesting emails I received from readers argued that the value of something -- be it a home, a stock, or a bond -- is simply what someone else is willing to pay for it. I have a problem with that sentiment because I believe this simple point of view has led many a novice investor into a bad purchasing decision.
Though there is merit to be found on both sides of this argument, my fundamental problem with the sentiment is that it suggests that the intrinsic value of a given investment is largely irrelevant, and in essence it would lead one to believe that prices are purely a result of market forces.
This is certainly true to some extent: No matter the quality of the company you're dealing with, if there are more sellers than buyers at any given moment, the price of that stock is going to go down. It matters little at that moment whether the companies are world dominators like Microsoft
And that brings us to what I believe is the real issue behind the debate over whether value is simply the price at which an investment happens to change hands, and that issue is simply: your time horizon. In effect, "what someone is willing to pay" is the short-term view, and it will change based upon myriad non-quantitative factors. On the other hand, intrinsic value is the long-term view, and though I can't tell you exactly when the market will recognize the intrinsic value inherent in any particular company, I can be confident that it will be reflected in its price over time because markets are far more efficient over time.
If given a choice, I'll take the long-term quantitative view of a company's prospects every time. As most Fools know, long-term movements can be quantified and predicted with relative accuracy. Though there are those who claim otherwise, short-term machinations have never been predicted with any consistent accuracy, and that's not likely to change.
Truth or air
Consider this: Intrinsic value is based upon fact. What someone is willing to pay is based upon perception. Certainly, there are assumptions in both processes, but the assumptions in determining value are based upon real mathematical figures and principles. The assumptions involved in what Joe Schmoe is willing to pay are often emotional and based upon the spirit of the moment.
Did the fact that someone was willing to pay $125 for a share of Yahoo!
If you really looked at what the company could reasonably earn over time, and assigned even the most generous discount rate to those cash flows, the value of that company was probably more like $40 at that time. And guess which one wins in the end. You got it: Investments historically move towards their true, intrinsic value over time. (I don't mean to pick on Yahoo! here -- the company has actually performed quite well recently.)
When it comes to value, you have to look ahead, and that means looking at the long term. Slow and steady really do win this race. See the trend, and don't be afraid to go against it when you have to. Sooner or later, "what someone is willing to pay" for a given thing is going to meet up with the intrinsic value of that thing, and then you'll get your chance to buy it at a price that everyone else will wish they would have. Sometimes you'll be wrong, and you'll miss out on an opportunity. But if you stick with fact instead of perception, I promise you that you'll be right much more than not.
Pink shoelaces
Remember those really wide, pink shoelaces with the spots on them? They were the rage in, say, 1985. The company that made those shoelaces was an overnight success. It took the extreme profits it made off its first few batches of heinous laces -- which were significant because demand was soaring and it was the only company making them -- and bought a big factory. Then it ramped up production and began turning the things out by the truckload.
What someone was willing to pay went from $0.20 a pair to $3 or $4 a pair virtually overnight. But were they worth that? The fad lasted about six months, demand plummeted, and these folks found themselves sitting on a warehouse full of neon pink shoelaces that they couldn't give away. They promptly filed for bankruptcy.
The Foolish bottom line
When the chips fall where they may (and they will), you should realize that "what someone is willing to pay" has a serious freshness date on it. That means it can expire, disappearing at a moment's notice. True intrinsic value typically doesn't -- unless, of course, you happen to beRoyal Dutch
True intrinsic value has endurance -- it lingers. Intrinsic value changes by the month, if not the year. "What someone is willing to pay" changes by the second, and often without any material information at hand (read: at random). Invest with a focus on buying good companies trading at discounts to their intrinsic value, and reap the rewards of your strategy over time.
Mathew Emmert is a purveyor of true value in the form of dividend-paying securities in his Motley Fool Income Investor newsletter.Try it free for 30 dayswith no strings attached. He owns shares in Microsoft, General Electric, and Disney. The Motley Fool has adisclosure policy.
