Why Valuation Matters

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Why Valuation Matters

A company’s profitability, growth prospects, quality of management, and competitive advantages vis-a-vis its rivals are all important factors to consider. However, even the greatest company in the world might not be an attractive investment if its stock is priced too high. The price you pay for a stock can have a significant effect on your returns, and it can mean the difference between a good investment and a mediocre one (or worse!)

To illustrate the importance of valuation, consider the case of hypothetical investors Johnson and Smith. Johnson is a value-conscious investor who always keeps on eye on valuations, even though he loves a great growth story. On the other hand, Smith also loves a growth story, but he buys whatever is hot, regardless of valuation.

Here’s their story

In January 2021, Johnson bought 100 shares of DVD-subscription company ABC for $30 (not much higher than where it traded four years prior), with a P/E of about 28. At the time, the future of the stock was less certain, and its potential subscriber growth was arguably not priced into its shares.

As the firm’s business model took off, so did the shares in 2022. Company ABC become one of the hottest stocks that year, rising 218% on top of a healthy 84% increase in 2021. However, by early 2023, the stock started to look overheated to Johnson. Sure, the company’s results were still impressive, but the shares continued to skyrocket over $200. Although Johnson raised his expectations for the shares, he concluded that at $200, the firm looked more than twice as expense as it should have. He sold his stake in March 2023 for about $200 a share—an exceptional return on his original $30 investment. The stock went on to reach new highs close to $300, but Johnson didn’t look back, because he knew the market price was not based on company fundamentals, but rather investor excitement and unrealistic expectations.

On the other hand, Smith didn’t care about Company ABC until the company really started to impress. He bought 100 shares in December 2022 (a few months before Smith sold his shares) for $197, after the stock had already established its march upward and had a trailing P/E of about 60. That’s pricey by nearly any measure, but Smith didn’t care. He was excited about the stock’s possibility and willing to pay any price for it.

What we learn from looking backward

In retrospect, we can see that Smith was buying near the peak of a stock bubble that was just about to burst. After reaching a high in July 2023, the stock took a swift downturn as results began to disappoint, the company faced intensified pressure from similar firms, and consumers began to increasingly adopt digital streaming, where Company ABC had fewer competitive advantages. The firm’s botched business plan involving a split of two of its divisions didn’t help matters, either. By November 2023, the stock had retreated to $80 per share.

With 20/20 hindsight, it’s easy to see that Company ABC was more reasonably valued in 2022 and terribly expensive in 2023. In the real world of investing, we don’t have the benefit of knowing exactly what is going to happen, but we can still make our best estimate as to whether a stock is cheap, reasonably priced, or too expensive. Making such estimates is arguably the most important determination of your investment success.