The so-called "hard" efficient market theory, in which market prices of assets reflect all there is to know about an asset, and that trades occur at fair value, has over time fallen out of favor. Some would even say it has been fully discredited as academic nonsense. This is in large part thanks to the rise in the far more accurate real-world behavioral finance approach.
The belief is that humans are not always rational, the prices they pay for assets do not always make perfect sense (or even follow reason), and markets do not always reflect how the economy is truly faring, for a number of reasons. When stock prices begin to fall, new investors sometimes freak out because they have not yet learned that every single asset has two prices.
Whether you are just starting to invest for the first time or working to balance a long-held portfolio, you should be mindful of the way you assess the value of your assets and expand your thinking to include more than one method.
How Do Intrinsic and Present Value Differ?
Value in itself can be a tricky concept. What is an asset worth? A simple way to answer that question is that it is worth what someone will pay for it, or in other words, present market value. Or, is value a more complex measure that should include its worth in the future as well? These two concepts are defined as follows:
- The Intrinsic Value: The approximate net present value (NPV) of the after-tax cash flows anticipated between now and the end of time
- The Present (or Market) Value: What other people are willing to pay you for the asset at any given moment
The intrinsic value and the market value often line up over time due to human behavior. When life is calm and there's nothing strange going on in the world, people are mostly calm, and they act in ways we can often predict. But there can be times or conditions under which people's actions will diverge wildly. You know this on some level, whether you realize it or not.
Panic selling is often touted as the main cause of market crashes. Black Tuesday is the most notorious example, when the market went into freefall and over 16 million shares were traded, and billions of dollars were lost, leading to the major crash and Great Depression of 1929.
An Example of the Role of Values When Buying and Selling
Imagine you own an ice cream stand near a popular events center in a major city. From selling shakes, malts, ice cream cones, hot dogs, and soda, you earn $30,000 a year in after-tax income on net tangible capital of $30,000. This makes for a hefty 100% return. Each summer, you hire a few young people to run it, make sure things are going smoothly, and you collect the stream of earnings. Your stand will never grow much beyond the rate of inflation, but it's a lucrative little operation.
Now, suppose someone approaches you and offers you $5,000 to buy it. You'd laugh in their face. Why? Even if you haven't bothered to perform the actual intrinsic value calculation, you already know the market value they offer is a mere fraction of that intrinsic value. There is no way you're going to accept something so low.
Now, picture this person offering you $3,000,000. You'd jump on it in a heartbeat because even without doing the math, you know the market price that is being offered far exceeds the intrinsic value. You could never make that much from the ice cream stand, so you're better off taking the cash and investing it in something else.
Productive Assets With Intrinsic and Present Values
All productive assets in the world work the same way. Stocks, for instance, are simply portions of ownership in ventures like the ice cream stand. To make smart choices when you invest, you have to look at what you're getting for the market price at any given moment with a much wider lens. This means that you shouldn't rush to sell a great holding just because the market price might exceed its intrinsic value at any given time. Real money—the life-changing, generational type of wealth—is more often made by holding on to solid moneymakers for years, or decades even, and not trading. (If you doubt it, I'd suggest a deep dive into the time value of money, and the power of compound interest.)
How many traders do you know who have bragged about a quick 20% gain buying a firm like Coca-Cola at one price and selling it quickly at a higher price, or trying to flip it as if it were a piece of rundown real estate? Instead, the more common path to wealth happens to people who parked a single lump sum in this solid stock on the day it was born, reinvested their dividends, and did nothing else. If they had dumped $10,000 a year into those crisp, green stock certificates for the Atlanta-based juggernaut, the numbers would be breathtaking: They'd now be sitting on $1,020,939 in stock. This reflects a growth rate of 10,109.39%.
New investors are often pulled by news about traders who get rich quick off of meme stocks or bitcoin surges, and day traders of course can make a living by hedging bets on quick trades; but these methods come with greater risk than the long-term, wealth-building investment goals discussed here.
How a Well-Diversified Portfolio Can Help Balance Values
Even if you suffer from a failing stock now and then, as you are statistically likely to do, you can still make money in a well-diversified portfolio, as a result of the math of diversification. To provide a real-world example, Eastman Kodak stock has been on a bumpy path for the last few years, after the stock going to $0 due to the dividends and spin-off of the chemical division. In spite of this, a long-term investor who has held stock since the height of the firm's earnings still wouldn't have walked away empty-handed.
The exact degree of loss depends on whether you reinvested the dividends back into Eastman Kodak itself or the portfolio as a whole. The trade-off of risk and reward between the Coca-Colas and Eastman Kodaks of the world can be bridged through diversification and by keeping your portfolio balanced.