Johannes Strömberg

Price, Value and Margin of Safety

Price is what you pay; value is what you get.

— Warren Buffet

Price vs Value is one of the fundamental questions in investing but should be at the heart of most decisions.

Value is what something is worth to you. This could be money, time, happiness or whatever other metric you choose, even combinations of different metrics (something that saves time and brings happiness for example).

Price is what you pay to get and keep that Value. Again this could be in any metric or combination of metrics.

The point is to pay a lower Price than you get Value for.

The more expensive something is (in terms of Price) the more important it is to ensure that there is sufficient margin between your estimation of its Price and your estimation of its Value. Missing having a clear Margin of Safety can become very costly.

It is also important to note that neither Price or Value is constant and will vary over time. Something that was once considered cheap, Price less then Value, might become expensive, Price higher than Value, and also much riskier.

An example of this is the apartment we bought a couple of years ago. It was a renovation project but the layout was almost perfect and it was very centrally located. The Price was good and we thought it was good Value, thinking it was our last home while living in Malmo. With over 2 years of tearing down walls, fixing floors, walls and ceilings, creating a kitchen in a new location and renovating our two small bathrooms we had a busy and dirty time. It was also quite expensive. Fortunately the renovation and general market changes increased the market Value of our apartment much more than we spent on it. It increased enough to reduce our total cost of living to basically zero. Unfortunately it also made the future Price of owning it more expensive. This was mostly due to the alternative costs of a comparable rental apartment without bound cash. It was over 10% more expensive than a rental at that time. With the Price increasing much more than its Value to us the apartment also had an increased risk that the market would Value it even lower as the Price should naturally be lower than a rental as the inherent risk of owning is higher. The Margin of Safety was gone. I convinced my girlfriend to sell it.

Buying Companies that cost much less than what they are worth and selling them when they are not is the key to basically all great fortunes.

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.

Operations not meeting these requirements are speculative.

— Ben Graham

The Price vs Value equation can be applied to almost anything. THis includes eating out, booking a holiday or even relationships.

Money can be a very abstract thing to value so for normal spending I often translate the cost of money into the time I would need to work in order to get that money. If I make $20 per hour working then every $20 that I spend today, at age 43, I will need to work at least 4 hours extra during my life time due to compound interest. Think about all the small unnecessary costs you have or even better on the bigger ones.

The importance of Margin of Safety can not be understated. Anything with a Price higher than its Value will most likely become a loser with time.

It takes character to sit with all that cash and to do nothing. I didn’t get to where I am by going after mediocre opportunities.

– Charlie Munger

It is also very important to remember that this is mentally hard. Planning for future gains with small losses today goes against human nature. Maybe that is why nobody is planning for retirement?

The big money is not in the buying and selling. But in the waiting.

– Charlie Munger