Dan Kline explains why flexibility is important when considering stock valuations.
December 22, 2020
Long-term investors can pay $20 for a $10 bill as long as they believe that what they’re buying will ultimately be worth more than what it costs now. Valuation matters. But the question isn’t what the value of a stock is now, but rather where you believe it will be three, five, 10, or even more years in the future.
That means that as you invest, it’s important to understand where a company stands now and what its future roadmap looks like. Do you believe that revenue, profits, and customers will grow in the way that company management says it will? If you do, then you can make some very educated guesses about where the share price will go over the long-term.
Of course, valuation isn’t tied to any one metric. Stocks are worth what people are willing to pay for them. That means that some — maybe too much — future growth can be priced into current prices. When that happens it does not mean that share prices won’t climb (the market can be disconnected from any sort of logic). But it might mean you think the stock is overvalued and that it may not be one you want to own right now.
I’m a somewhat conservative investor and I tend to buy fairly established stocks. I rarely chase the “hot new thing” and my portfolio largely consists of stalwarts — companies that have done well and which I believe will continue to grow their businesses for a very long time.
When I’m buying shares of companies like that — think Starbucks or Microsoft — I think very little about valuation. These companies have a steady path to growth and multiple avenues that will keep them adding sales, customers, and profits.
I do, however, consider valuations more carefully when I stray outside my comfort zone. My portfolio includes one fairly speculative stock in the cannabis space and I did check its valuation before I bought some shares. There wasn’t a specific number in my head, but I did check to make sure this very early stage company that still has to prove out its growth model did not have an outsized market cap.
The challenge, of course, is knowing when a valuation is too high. People have spent years thinking Amazon was overvalued and the company proved that it can steadily rise to new heights. Many have thought Tesla shares are priced too high and are thereby due for a crash, but that has not happened either.
Valuation matters but it’s more a “does this company’s valuation pass my personal smell test?” kind of question than any specific metric. Be very wary of internet/social media darlings with no products and no earnings trading based on what might happen. That’s not to say you can’t find winners in pre-revenue companies — you most certainly can — but you have to really do your homework.
Is Zoom overvalued? Some would argue vociferously that it is, while others believe the company has massive growth potential. I’m somewhere in the middle in that I believe it will grow, but it may take years to truly to get sales levels that justify its current price. Because of that, while I like the company and use the product, I have no interest in owning shares at the moment.
Valuation matters in that if you believe a company’s share price has risen faster than its growth justifies, you may choose to hold off on investing or put your cash in a stock you think has better prospects. It’s a piece of the investing puzzle — a deciding factor that might help you pick between two stocks whose business prospects you really like — not a core part of the investing thesis.
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