The other day I was chatting with my father about the stock market when he mentioned that he liked General Electric ($GE) because it was cheap. I cringed immediately. Every time I hear someone use “cheap” to describe a stock it takes every ounce of my being not to go into full rant. This is not the first time he has used this word nor is he the only one to use this word so freely (pun intended?).
The use of “cheap” as a descriptor seems innocent enough until you start to think about its actual meaning. Merriam-Webster defines cheap as any of the following:
- Charging or obtainable at a low price
- Purchasing below the going price or the real value
- Depreciated in value (as by currency inflation)
These three meanings are very different. In most conversations, I would assume that the average person implies the first or second meaning. However, the usage tends to be a bit implicit and ambiguous. Think about your last trip to a clothing store with a friend. Back in the pre-COVID days of normalcy. A conversation might go like this.
Jack: Woah. Jill, look at this jacket. It’s on sale for only $39.99.
Jill: Yeah, that is so cheap! You should totally buy it.
When Jill described the jacket as cheap, what do you think she meant? Was she implying that the jacket was a low price or that it was below the real value of the jacket? Does the difference in interpretation matter in this context? Let’s continue to see what happens next.
Jack: Wait a minute. The tag says it is U.S. Polo. I thought it was Ralph Lauren.
Jill: Oh wow. Yeah, let’s keep looking for a better deal then.
With a quick change of the brand, the jacket appears to no longer be “cheap” to Jack or Jill. So what happened? If Jill implied that “cheap” was simply a low price, then the decision shouldn’t change. However, it seems that the product was only “cheap” when they thought it was a Ralph Lauren brand. Jack and Jill must place a higher value on a Ralph Lauren jacket than a U.S. Polo jacket. It appears that the jacket was only worth purchasing when the price was below their perceived real value of the jacket.
In finance, the real value of a stock is often referred to as its intrinsic value. In finance, the real value of a stock is often referred to as its intrinsic value. The intrinsic value of a stock is independent of its market price. The market price is the value you see when you google a company’s stock price. This is the amount if would cost to purchase a share in any brokerage account. On its own, the price of a stock tells you nothing about whether you found a good deal. It is only one piece of the puzzle to determine the market value of a company. The market value is the amount quoted when journalists say things like, Apple was the first 2 trillion dollar company! Market value, or market cap, is determined by multiplying the current price per share times the total number of outstanding shares in the company. Because companies have different numbers of outstanding shares, comparing their stock prices is not an apples to apples comparison. In order to determine whether the price is a good deal, financial analysts will often compare the market price of a stock to its intrinsic value.*
So how do you calculate intrinsic value?
According to Benjamin Graham, the founder of value investing, the intrinsic value can be found by using a company’s factors such as its assets, earnings, and dividend payouts. Because the market price of a stock will deviate from its intrinsic value, Graham suggests that you aim to purchase the asset when the market price is below its intrinsic value. In theory, he claims that the market price of a stock will always converge towards its true value in an efficient market (Source).
Whether you believe that the market is efficient, or that Graham’s value investing approach makes sense, is irrelevant. The main takeaway, that any financial analyst worth one’s salt would agree upon, is that the market price of a stock is not always equal to its real value. A share of GE costs $7.38 as of mid-day on October 30th; however, the real value of GE is not necessarily $7.38. If you cannot calculate a reasonable estimate of the real value, then how could you know if the market price is above or below it. Just like the jacket, GE’s low price might be tempting, but that does not mean it is cheap. You might want to keep looking for a better deal.
*Intrinsic value is not the only variable at play to determine whether you purchase an asset. The scenario is simplified to demonstrate a lesson.