Answered this question on Quora yesterday and thought it would be interesting to re-post here:
The key to understanding “value” is to separate it from “price”.
“Price” is the amount of a given currency at which a buyer is willing to buy or a seller is willing to sell (sometimes, those numbers overlap, in which case a deal is made).
A lot of people assume that the value of an asset is equal to its price, but that is not true.
Consider the example of a crazy person who walks up to you and offers to sell you his brand new, mint condition Porsche 911 for $500.
You would jump on that deal, right? Why?
Because you know that the Porsche is worth way, way more than $500. Another way to say this would be: “The value of the Porsche is higher than its price”.
How does this relate to stocks or real estate?
Well, a knowledgable investor is constantly reviewing information about asset classes (stocks, real estate, whatever) in which he is interested. He forms opinions about the assets involved – how much cash they are likely to generate, whether they are likely to appreciate or depreciate in value over the coming years, what other investors are paying for similar assets, etc.
Over time, this knowledgable investor gets a feel for the “value” he puts on these assets – eg what he thinks they are worth to him.
Over time, the prices offered by the market for those assets will fluctuate (based on investor sentiment, interest rates, economic growth rates, etc.), as will his estimates of the values of the assets.
Occasionally, the market will offer to sell the investor assets at prices which are materially below his estimates of their value, at which point he will buy.
And, on other occasions, the market will offer to buy assets from the investor at prices which materially exceed his estimates of their value, at which point he will sell.
Whether the investor is successful over the long term will depend to a large extent on whether the judgements he makes about value prove to be correct.
(For more on this, google “Allegory of Mr. Market” – it’s amazing.)