Finding the Middle Ground on Valuation
December 22, 2020
Some investors place valuation on a pedestal, making it the defining characteristic of their investment process, placing it above all else. Others seem to value it (no pun intended) as something entirely insignificant. So let me set the record straight: Valuation matters, but traditional valuation metrics are far from the end-all and be-all of investing.
Along with growth and margins, valuation is usually one of the first things I look at in a company, to see if a company’s numbers seem to make sense. If a company is growing revenue at 10% with a price-to-sales (P/S) ratio of 50, I can quickly pass with a note to revisit from time to time. With finite time to study and learn about stocks, I find this an invaluable hack to help me direct my attention to better current investment opportunities.
After studying a company extensively, I again return my attention to its valuation, this time with much more vigor. Before investing, I must believe that the company’s future cash flow expectations will give shareholders a decent return. If not, but if I like the company’s economic moat and/or optionality, I might make a small investment to keep it on my radar. Over time, even if the price appreciates, I can almost always buy in at better valuations, slowly building a larger position in the company.
I do believe the “market” is currently overvalued. The problem with that takeaway is that if I was being honest, I would admit that I also thought the same thing last year. And the year before. And the year before. In fact, since I’ve been investing there are very few times I didn’t think the market was overvalued! This is why, as an investor with a long-time horizon and someone who is still working and can continually add to my portfolio in the coming years, I continue to buy shares of my favorite companies and participate in the stock market.
As for a company that is consistently called overvalued but which I believe is still, in reality, undervalued, is Mastercard (NYSE:MA). At a forward P/E ratio of about 40, shares certainly look expensive! But with a durable economic moat and operating margins consistently above 50%, I believe Mastercard will reward shareholders richly for many years to come.