Author Dave Van Knapp
EXCERPT FROM CHAPTER D-1: WHAT IS VALUATION AND WHY
DO YOU NEED IT?
Why Valuation Is Important
It is a basic tenet of Sensible Stock Investing that there is a difference
between the excellence of a company and the potential of its stock as an investment.
The excellence of a company has been discussed in Part C. Boiled down,
company excellence is based on a company’s high probability to sustain
earnings growth over a meaningful period of time.
Assuming that an excellent company has been found, the next step in
Sensible Stock Investing is to determine whether and when to buy it. Every
stock’s price changes from day to day, meaning that opportunities to make
investments in great companies at favorable valuations come and go
regularly.
While it is rare that a lousy company can make a great investment, it is
often true that a great company can be a lousy investment. That’s because if you
pay too much, you get too few shares for your money, and the stock’s
overall return is likely—if not doomed—to be subpar. That’s why we have
to carry our analysis beyond simply identifying excellent companies.
If you pay too much for a stock, it’s as if the stock has a steel ball chained
to it. Sad to say, for the rest of the time you own that stock, your returns
will suffer because you paid too much for it. Sooner or later, unless a
bubble or other improbable market phenomenon bails you out, the
inexorable grinding rationality of the market will cause that price to come
down. This unfortunate result is practically foreordained at the time you
overpay for the stock. The truth is that valuation will play as much a role in
the returns you generate as the performance of the companies whose stocks
you buy.
Of course, the same logic works in reverse. If you are fortunate enough to
be able to grab some stock in a great company at a price that is beneath
what the market will eventually decide is its true value, the relentless logic
of the market will work in your favor. Buyers will come to the stock,
pushing its price up.
DO YOU NEED IT?
Why Valuation Is Important
It is a basic tenet of Sensible Stock Investing that there is a difference
between the excellence of a company and the potential of its stock as an investment.
The excellence of a company has been discussed in Part C. Boiled down,
company excellence is based on a company’s high probability to sustain
earnings growth over a meaningful period of time.
Assuming that an excellent company has been found, the next step in
Sensible Stock Investing is to determine whether and when to buy it. Every
stock’s price changes from day to day, meaning that opportunities to make
investments in great companies at favorable valuations come and go
regularly.
While it is rare that a lousy company can make a great investment, it is
often true that a great company can be a lousy investment. That’s because if you
pay too much, you get too few shares for your money, and the stock’s
overall return is likely—if not doomed—to be subpar. That’s why we have
to carry our analysis beyond simply identifying excellent companies.
If you pay too much for a stock, it’s as if the stock has a steel ball chained
to it. Sad to say, for the rest of the time you own that stock, your returns
will suffer because you paid too much for it. Sooner or later, unless a
bubble or other improbable market phenomenon bails you out, the
inexorable grinding rationality of the market will cause that price to come
down. This unfortunate result is practically foreordained at the time you
overpay for the stock. The truth is that valuation will play as much a role in
the returns you generate as the performance of the companies whose stocks
you buy.
Of course, the same logic works in reverse. If you are fortunate enough to
be able to grab some stock in a great company at a price that is beneath
what the market will eventually decide is its true value, the relentless logic
of the market will work in your favor. Buyers will come to the stock,
pushing its price up.
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