In finance, the terms price and value are not really interchangeable. An asset’s fundamental value can only be its price if well informed investors pay for it in a free and competitive market. The essence of asset valuation is to estimate how much an asset is worth using information about one or more comparable assets whose current market price we know. By the law of one price, which is enforced through arbitrage, if two assets are equivalent they will tend to have the same market price.
Value therefore comes from fundamentals which represent the capacity of the asset to generate and grow cash flows. Analysts determine this by an intrinsic valuation process which looks at projected cash flows from the asset and discounting the same using a risk adjusted weighted average cost of capital. Fundamental analysts attempt to estimate value by a thorough analysis of financial statements and accounting data like price-to-earnings (P/E) ratios, sales or profits growth rates, dividend yields , the prevailing rates of interest and other parameters.
The essence of value is that it comes from a company’s earning power evidenced by what is happening within the corporation. Such information is what causes cash flows to move and risks to be examined closely. This information is what will influence the value of the asset. Fundamental analysis looks at the intrinsic value of a company and its long-term viability.
This value is not necessarily captured by price. Pricing is a market process. Simply put, price represents the point at which demand and supply intersects at a given point in time. Because the market is not necessarily rational, price is oftentimes influenced by non-fundamental behavioral factors like market mood, sentiment and momentum shifts. Prices can then move up and down based on some patterns not necessarily related to the intrinsic value of the asset. In the short run, the price may be out of sync with real value, but the long run must correct such deviation.
Understanding these differences will illustrate how decisions are made in stock investing. Those who believe in fundamental analysis approach investing by making judgements on value and how far it is from the observed price. When intrinsic value is greater than the observed price, it is a signal of a stock buy. When price seems high relative to the fundamental value, the analyst will make a sell recommendation.
This is the investment mode recommended by icons like Benjamin Graham and Warren Buffet. It is embodied in Buffet’s advice that investors should consider buying not the stock but buying into the company. For this reason, he puts no credence in day-to-day movements in stock prices.
On the other hand, there are analysts who recommend buy or sell decisions by simply looking at movements in price and identifying possible patterns. Those who rely on technical analysis are the traders. Technical analysis studies the company’s historical stock prices with a view to identifying how history will repeat itself. They look at mood shifts and momentum changes, hopefully earlier than the rest of the market. Trading involves making judgment on future price direction based principally on patterns and an assessment of behavioral reaction to information flows. They trade and buy an asset because they believe they can sell it to somebody at a higher price.
Technical analysis checks attempts to identify trends, principally using charts as their tool of trade. They look for levels where prices historically don’t fall and label this the support or floor. They also evaluate levels where prices historically rise, the resistance or ceiling. They try to determine when there is possible breach of either the floor or the ceiling. The technician looks at volume inputs, moving averages, relative strength and other indicators. They use measuring standards and attempt to find some statistical patterns that persist. The idea is to identify momentum shifts ahead of other market players.
In summary, market players are either value investors or price trackers. Despite the oppositeness in nature of technical and fundamental analysis, reality check will reveal that they can be used to support each other. Nonetheless, it is important to know the clear distinction between value and price.
(Benel D. Lagua is Executive Vice President at the Development Bank of the Philippines. He is an active FINEX member and a long time advocate of risk-based lending for SMEs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.)