Finance problem

The Pricing Game versus The Value Game

The Pricing Game The Value Game

Underlying philosophy

The price is the only real number that you can act on. No one knows what the value of an asset is and estimating it is of little use.

Every asset has a fair or true value. You can estimate that value, albeit with error, and price has to converge on value (eventually).

To play the game

You try to guess which direction the price will move in the next period(s) and trade ahead of the movement. To win the game, you have to be right more often than wrong about direction and to exit before the winds shift.

You try to estimate the value of an asset, and if it is under(over) value, you buy (sell) the asset. To win the game, you have to be right about value (for the most part) and the market price has to move to that value

Key drivers Price is determined by demand & supply, which in turn are affected by mood and momentum.

Value is determined by cash flows, growth and risk.

Information effect

Incremental information (news, stories, rumors) that shifts the mood will move the price, even if it has no real consequences for long term value.

Only information that alter cash flows, growth and risk in a material way can affect value.

Tools of the game

Technical indicators Price charts Multiples & Comparables Investor psychology

Ratio analysis DCF valuation Excess Return models

Time horizon Can be very short term (minutes) to mildly short term (weeks, months).

Long term

Key skill Be able to gauge market mood/momentum shifts earlier than the rest of the market.

Be able to “value” assets, given uncertainty.

Key personality traits

Market amnesia Quick acting Gambling instincts

Faith in “value” Patience Immunity from peer pressure

Biggest Danger(s)

Momentum shifts can occur quickly, wiping out months of profits in a few hours.

The price may not converge on value, even if your value is “right”.

Added bonus Capacity to move prices (with lots of money and lots of followers).

Can provide the catalyst that can move price to value.

Most Delusional Player

A trader who thinks he is trading based on value.

A value investor who thinks he can reason with markets.