Great companies aren't always great investments.
''Buy stocks as you would groceries - when they're on sale''
Because investing in a great company at an awful price makes it a bad investment. Compare it to doing your groceries. You walk into the supermarket and all of a sudden the price of the beer you normally drink tripled in price. What do you do? If you are like most people, you would switch to another brand of beer that's a lot cheaper. Why? Because we're used to looking for the best price / quality products when doing groceries. We should apply this same concept to investing. As value investor Christopher Browne said:
“Buy stocks as you would groceries - when they are on sale.”
Great companies can become bad investments really quickly when you pay a price for a stock that's way too high. While this concept is pretty simple, it can be hard to determine what price is too high and what price is not.
Determining if the price of a stock is attractive or not, is what we call stock valuation.
At What Price Are Great Companies Bad Investments
When we do stock valuation we look at the fundamental factors of a company. This means we're going to look at the financial statements of a company, and determine if its current market price can be justified or not. A company is overvalued if it's priced higher than what you think is a justifiable price. Take a quick look at valuation ratios if you want to analyse whether a great company is overvalued. They can tell you a lot.
Valuation ratios that you can use are:
- Price – Earnings (P/E) Ratio
- the Price – Book (P/B) Ratio
- Price – Cash Flow (P/CF) Ratio
- PEG Ratio
These ratios indicate how the stock is priced compared to fundamental factors such as earnings (profit), book value and operating cash flow. Thus, these ratios can give you a quick indication whether the company is overvalued or not.
Interpreting Ratios (to help determine great investments)
How to interpret all of these ratios differs per ratio and per industry. High growth industries such as technology and pharmaceuticals tend to have higher average ratios compared to slow growth industries such as utilities, industrials and chemicals.
The fact that high growth industries have higher average ratios makes sense, since the potential profit is way higher in those industries. You're willing to pay a higher price for a company that's growing faster compared to a company that's growing slowly.
Therefore, in order to make sense of the ratios you need to do 2 things :
- Compare the current valuation ratios with the valuation of the past 5 – 10 years of the same companies
- Compare the current valuation ratios with the valuation of competitors from the same industry
Only if you perform these two steps, can you determine whether a company is overvalued or not.
Let’s take a look at a real life example of an overvalued company and how investing in it went wrong.
We all know Microsoft. Microsoft is a great company. Especially in the 2000’s. If you were an early investor in Microsoft, you would have made millions. However, there was a period that investing in Microsoft could have gone incredibly wrong.
If you would have invested your money in Microsoft during the dot-com bubble in 1999 / 2000, you would have lost a lot of money on your investment. It would take almost 20 years before Microsoft would reach its high price again.
See how Microsoft dropped massively after the 1998 mark and didn't recover until 2016?
How could this have been prevented?
Now the thing is, we could pretty easily see that Microsoft was overvalued if we simply compared the valuation of Microsoft in 1999 / 2000 with the valuation of the years before. At the height of the bubble, Microsoft’s P/E Ratio was 57. It’s P/B ratio was 17, which is really high. Compare this to the P/E ratio of 26 in 1997 and we see that it’s valuation has doubled in only 3 years. This should have served as an indicator of overvaluation.
Emotions got in the way
The problem during that time was that emotions got the better of investors. There were many other companies that were valued much higher, so Microsoft looked cheap. However, looking at the valuations of Microsoft before the dot-com bubble would have served as a big red flag for investors.
If we compare the valuations of Microsoft during the dot-com with that of today, we clearly see how overvalued Microsoft was back then.
We can clearly see that today, Microsoft has a better valuation compared to the dot-com bubble.
So as you see, investing in an overvalued company can lead to pretty nasty results. And let’s be fair.. You wouldn’t have bought your car if it was 2 or 3 times as expensive right? So why would you buy a stock that is?
‘It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’ - Warren Buffett
To use the words of Warren Buffett, wonderful companies can be great investments when they are bought at a fair price. This implies that wonderful companies don't necessarily have to be undervalued. A fair value would simply be enough. This is because a wonderful company will earn returns that are higher than that of the market average, which will eventually reflect in the stock price.
It would be even better if the company was undervalued. Because studies have shown that low P/E and low P/B outperform high P/E and high P/B etc.
For example, a study done by Roger Ibbotson showed that investing in low P/E stocks earned you 6x as much as investing in high P/E stocks. Also, investing in low P/B stocks earned you 2x as much as investing in high P/B stocks. This clearly shows that you should look for companies with lower valuation ratios.
Side note: if all this talk about ratios isn't making much sense to you, don't forget that you can click on the links earlier in the article and quickly read about them 🙂
SO. When is a company attractive?
So in order to determine if the price of a great company is attractive, we need to do exactly the same as before. We need to look at the following 2 things :
- Compare the valuation ratios of today with the valuation of the past 5 – 10 years of the same companies
- Compare the valuation ratios of today with the valuation of competitors from the same industry
If these ratios are equal or lower compared to historical valuations and current valuations of competitors, it at least indicates that the company isn’t overvalued. Now you need to look deeper into the financial statements in order to determine the true value of a company.
Analyzing a Company Further
Note that these valuation ratios are a quick way to value a company, but not necessarily a deep and accurate way. To actually form your final verdict on the company, always look at the financial statements. This shows how a company earned its profit.
Look at how much operating income and free cash flow it generated. Analyse which segments are doing well, how the management is performing and how financially healthy it is.
These are all factors to consider, but they require a lot of time. The good thing about using ratios is that it's a quick method of filtering stocks that don't look good on the surface. Analyse those that do look good further.
If you want to learn more about stock valuation, we have something exciting for you, coming the next few weeks..
All in all..
Investing in great companies doesn't equal making great investments. We saw that when you invest in a great company that's overvalued, things can go horribly wrong. Make sure you invest in great companies for a price at or below fair value in order to make a great investment!