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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