Distinguish between the value of a security and its price. Under what conditions would value equal price?
The value of anything is what it is worth to someone. We model a security’s value as the present value of the cash flows the investor expects to receive, where the discount rate used to calculate PV contains the appropriate inflation and risk premiums. Since different investors will forecast different cash flows and risks they will each calculate different values, even though we can model their analytical process in the same time-value-of-money terms. The price of a security is the amount it can be bought or sold for in the financial marketplace. Price is determined at the margin by the actions of those investors who are currently buying and selling the security. For a publicly traded security, this number is quoted constantly and is the same for all investors. For some investors, value will equal price if they happen to forecast cash flows and a required rate of return that produce a present value equal to the market price of the security. Other investors will not do such a detailed analysis but will accept that the market where the security trades is sufficiently efficient that the security’s price accurately reflects its value. The remaining investors will calculate value numbers that differ from the security’s price and will consider it overvalued or undervalued.
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