Knowledgeable investors realize that a great business does not necessarily make a great stock. This is because great businesses often attract investors into purchasing shares, and they drive the share price up to quite high levels. When this happens, even if the business does very well over the next few years, returns may be lackluster because the shares were overvalued to begin with. Just ask Coca Cola stockholders how their last 15 years have went.
Luckily for value investors, not all great businesses are loved by investors. Sometimes a great business is too small to be heavily noticed. Sometimes a great business is in a hated industry, and they are overlooked. Sometimes a great business is great for reasons too subtle for many to detect. Sometimes a great business has recent bad news that scares investors away. Sometimes a great business is just plain boring, and so it flies under the radar.
As an example of how price matters, I’m going to use two imaginary companies as an example.
Current Time:
Company A currently trades at a P/E of 22.22 and has 14% growth.
Share Price: $30
Earnings per Share: $1.35
Company B currently trades at a P/E of 13 and has 12% growth.
Share Price: $30
Earnings per Share: $2.31
Ten Years from Now:
Company A has indeed had 14% annualized growth, and earnings per share are now $5.00. But, over 10 years, the excitement has worn off a little bit, though not too much, and the P/E is only 20. This gives a share price of $100. Annualized over 10 years, that’s a 12.8% rate of return.
Company B has had “only” 12% annualized growth, and earnings per share are now $7.17. The constant great growth of this company, however, has caught attention and has increased the P/E to 17. So, the share price is $122. Annualized over 10 years, that’s a 15.0% rate of return.
Conclusion
That doesn’t sound like much of a difference, and both were definitely good investments, but consider this:
$50,000 compounded for 10 years at 15.0% is $202,000.
$50,000 compounded for 10 years at 12.8% is $167,000.
The difference is $35,000 and that is more than some people make in a year.
This is not to say that high valuation companies should always be avoided. It depends in part on your preferences, interests, and goals. It’s just healthy to keep in mind that the current valuation of the company matters just as much as growth prospects. What makes a “value” company is a strictly relative term, since a company could have a high P/E but due to high growth prospects, actually be undervalued.
Invest Diligently!
Full Disclosure: Long KO.
You can see my full list of individual holdings here.
{ 2 trackbacks }