You're in a restaurant for a dinner. It's a pretty nice place, and your options include anything from basic dishes like pasta or chicken to elaborate and pricey ones, like lobster or surf and turf.
So what do you order?
If you're like most people, you'll probably choose something more or less in the middle of the menu, right? You don't want to look like a jerk for getting the surf and turf, but you also don't want to give the game away by ordering the much cheaper baked chicken. So you get something like a sirloin -- it's pretty nice, but not so nice as to be obvious.
In other words, you make a decision based not on how much you think dinner should cost, but on where the price of a particular dish falls into the spectrum of prices on the menu.
Seems logical, right? Now ask yourself this: How much is the sirloin actually worth -- $20, $50, $120?
Why is this so hard?
It's difficult because, as one study shows, we're a lot better at figuring out the relative value of something than the actual value. And by a lot better, I mean infinitely better; we're actually terrible at figuring out questions as simple as "How much should this cost?"
For example, a group of students listened to a recording of their professor reading a Walt Whitman poem and were then told that they were invited to attend a longer recital.
To determine their "interest level," the professor asked the students to write down the last digit of their Social Security number. Depending on whether the number was even or odd, the students had to express whether they'd pay the amount of that digit to attend or accept that amount in exchange for attending.
Of the latter group group, 63% were willing to attend in exchange for what was essentially a random payment.
In other words, most of the "accept payment" students agreed that the "value" of the recital was the same or less than their completely random Social Security digit -- even though they had all experienced the reading already and could presumably have determined how much they liked it (or not).
On the other hand, only 20% of students were willing to pay their digit amount to go to the recital.
While all the students were highly consistent in the relative values they gave for longer or shorter recitals based on the initial amount, those initial valuations were totally all over the place -- and completely dependent on the framework their professor gave them in thinking about whether they'd pay or accept payment for more poetry.
What does this mean? That putting the students in a "pay" or "get paid" frame of mind had more of an impact on valuations than their actual experience of the recital itself. How do I know? Consider that among those who were asked if they'd be willing to pay, 49% were willing to attend for free -- compared to just 9% among those who were asked if they would be willing to be paid. The difference was statistically significant, and really highlights that framing and its importance in determining valuation.
It's not that intuitive an experiment, so here's a handy flowchart for making sense of it:
Put bluntly, the students were apparently not thinking for themselves about the actual value of the recital. Kind of like how we figure $45 is OK for a steak when everything else on the menu is either $30 or $60.
What does this mean for me?
It drives home an important financial point: If we don't know what price something should be, we're open to all kinds of influence about whether it's reasonable or not.
The stock market presents a very good example. We know that if a company has a good quarter, its price should rise. But how do you know if the original price was a good one?
When you start thinking about things in this way, you realize that price is not necessarily a good indicator of worth. It's subject to so much noise: what happened yesterday, what everyone else thinks, and maybe even random cues like whether it's a round number or not.
This makes it all the more important to think for yourself in determining what a potential investment is worth. How do you do it? It all comes down to fundamental analysis.
The reason fundamental analysis works is that it reduces the amount of arbitrariness in your pricing. It cuts through the noise and helps us establish -- for ourselves -- what we think a stock is worth.
You start by tackling every stock with thorough bottom-up analysis.
This analysis should include the company's business model. Who are the competitors? How is the industry changing? What's the market share? Does the company's strategy make sense, or is it coasting on past success without a clear competitive edge for the future?
Pay attention to financials. What kinds of dividends or returns is the company generating? If it has big plans, can it afford to finance those plans? Are there any major red flags, like too much debt?
Build from there. Your fundamental analysis can be mostly mathematical, looking at financial statements and making calculations about dividend streams, or it can be more strategic, taking into account a company's management, operations, and competitive pressures.
In either case, the reason it works is that it forces you to figure out what the business is worth, and how that worth might change over the future. This is an incredibly powerful position, because, again, it cuts through the noise of the market and all the relative valuations being tossed around by people with imperfect information.
You won't always be right, either, but you'll at least be way ahead of the curve by ignoring all the noise. Instead of choosing the steak based on everything else on the menu, you'll be choosing the steak because it's worth as much or more to you than the price listed on the menu -- and that, in a nutshell, is a setup for real long-term investing success (and happy dining).
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