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The Pitfalls of Measuring Price and Value in Units of Variable Value

Measuring Price and Value
Written by Andy

You need to understand the difference between price and value – the ‘units of currency’ by which you measure price are themselves variable rather than absolute quantities as otherwise you can get yourself into a complete mess especially when you expatiate on the subject of gold and other commodities.

I have explained before that a chart plotted over the years in a unit (the £ or $) of variable value in fact shows far less of value than you think. Try plotting the price of a loaf of bread, or TV sets, over 20 years in ££ or $$ and what do you learn from it? That bread, and to a lesser extent TV sets are assets on a long-term price uptrend? The results would look very different if you plotted their prices in units of constant value. You might also find that a lot of your ‘support’ and ‘resistance’ levels changed or even disappeared!

A little bit of history to ponder for those tempted to adopt a simple conflation of price and value, and belief that all datums are imaginary.

During the inflationary period in the 1970s, many retailers dealing in slow moving stock were surprised and shocked to find that their businesses had gone bust while the accounts showed they were making good profits, in some cases the best profits they had ever made.

They sold for £1.50 each a shelf full of widgets shown in the accounts at their purchase price of £1 each, and a bottom line accounting profit of 50p per widget. So, the business was prospering. with a healthy 50% gross profit margin. They went to the wholesaler to restock the widget shelf, and were charged £1.75 per widget for the new stock, so they reached for the plastic and bought a new stock, which they marked up on the shelf at £2.75…and when that shelf full sold out they had made an even larger ‘profit’, so they went back to wholesaler to restock, and were charged £3 per widget, so they reached for the plastic (the wife’s plastic this time, as theirs was maxed out) which they put on the shelf marked up to £4.50. Then, as the bank was sending them lots of red demands, they went to see their accountants, to enquire how it was that although they were making splendid profits, for some reason they could not pay the bank demands.

That is absolutely true.

Why Nominal Price Alone is Not a Reliable Measure of Value

It is very common for people to think only in terms of nominal price, and utterly disastrous.

How many advertisements (all ‘honest’ and totally regulator compliant) have you seen telling you that if you put a few hundred a month into your investment account /pension pot you will retire a millionaire, and that the early years are the most important, as the first month’s payment will ‘grow’ many, many times more than the final one, so that a couple of years delay in starting will ‘cost’ you half your final return?

The fallacy lies in conflating price with value, and not measuring against an appropriate datum, such as replacement cost, or purchasing power.

No datum is appropriate for all purposes but, pace Tyke, that does not make datums are all ‘imaginary’.

Finally, a tip for investors – Elliot evangelists can skip this bit, because they believe that ‘fundamentals’ are irrelevant to investment decision making. When you look at the accounts of a trading company, look most closely at free cash flow. The bottom, profit/loss, line can (like a chartless chartist’s waves) be caused to show pretty much anything according to the accounting conventions used, but free cash flow (especially over a number of years so as to iron out year-end anomalies) tells the most accurate story. Not infallible – nothing is – and some interpretation and understanding of the accounting conventions applied and the nature and operation of the business helps, but as a ‘one stop shop’ free cash flow is the nearest thing to an acid test available to the average Joe.

Investment and price movement are not the mechanistic science you imagine. I do accept though that measurement in units of variable value, pretending that they are of constant value, opens up the field wonderfully to the charlatan.

About the author

Andy

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