Price Versus Value

Posted: April 26, 2008

Share prices are volatile, whereas the value of companies is usually much more stable.

The last edition of our newsletter included an article on volatility. As it’s turned out, it was a timely warning that investors can expect periods when the share market falls significantly in value. The last few months have provided a spectacular illustration of volatility in action.

After setting a record all time high on November 1, the Australian share market went into sharp decline. By January 21 it was 17.8% below its peak, then on January 22, it dropped 7.26% in a single day. No doubt many people decided this was the time to jump ship and sell out of shares, yet over the following three trading days, the market recovered 12.7%.
These large movements over short timeframes were extreme by historical standards. There are several reasons why they occurred, some technical, others emotional, but all related in some way back to the subprime crisis in the US.

In these periods of extreme volatility, it’s important to distinguish between price and value. Take Commonwealth Bank shares as an example. Like the market, CBA hit its high on November 1, when a share was worth $61.45. On January 31 the price had dropped 22.6% to $47.58. But what about its value?

Price is determined by the market, and is often based on short term views. Value, on the other hand, is determined by a company’s ability to maintain and grow its earnings in the years ahead. Future earnings aren’t always easy to predict, and with major banks in the US and Europe facing large losses on subprime mortgages, perhaps it isn’t surprising that Australian banks have also been sold down. However, our major banks have a good track record of increasing their earnings, they don’t appear to have significant exposure to subprime loans, and there have been no changes to the earnings forecasts of the four big banks over the last three months.

Sometimes a significant fall in share price is a sign of problems with the company in question. In the current cycle, Centro Properties Group fits this bill as there are serious concerns about its ability to retain its best assets and to maintain its earnings. But when the price goes down and the outlook remains rosy, it’s often the sign of a true bargain. All investors need to do is to be able to differentiate between price and value.