Does Valuation Matter?

Suppose you follow the stock market at all in any way and listen to any commentary. In that case, we are sure you often hear the "V" word or "valuation."

The accepted view of most market analysts is that valuation is the key driver of stock price performance.

Ask 95%+ of investment professionals if valuation is important, and they are likely to reply – "Is the sky blue?"

Well, just as the sky can sometimes be cloudy, the REAL answer is "sometimes."

Importantly, we think there is an overreliance on valuation as an investment metric that can cost investors a LOT of money!

Let us explain…

First, what does everyone mean when they say valuation?

There are many ways to measure it, but it usually means looking at the company's value against some measure of its profits.

The value could be measured by just looking at the dollar value of its stock. This is the "stock market capitalization."

It could also be measured by looking at the dollar value of its stock, bonds, cash holdings, and other assets. This is called its "enterprise value."

The profits can also be measured in many ways, including net income, earnings per share (EPS), free cash flow, and (the controversial) EBITDA. We could write individual notes on each of these measures and their usefulness, but that is for another day(s)…

Most analysts use a metric called “Price-to-Earnings Ratio” or the “PE Ratio”.

This looks at the price of the stock divided by the EPS. For instance - a $20 stock with $1 of EPS would have a PE of 20x.

By looking at the stock price and the EPS, we adjust for the number of shares and create a measure of profitability per unit of ownership.

What does it mean when an analyst says a stock is "expensive," and does this matter?

The analysts on CNBC certainly like saying it all the time, so it must be important, right?

What is expensive depends on how you are looking at the stock. Most often, the analysts look at it relative to the history of that stock or similar stocks.

Suppose a stock (or other companies like it) usually has traded in a range of 15x to 25x PE. In that case, if it is trading at 30x, it is considered "expensive." This also means that the analyst thinks it is riskier.

Is this true at all?

The answer is not really…

Our experience has been that valuation plays little of a role in the outcome of future stock prices.

What drives stock prices are the earnings of the company. If those are growing and the company is also beating investor expectations, the stock will likely go higher. Maybe a little, perhaps a lot, but higher…

Why do market pundits point to the concept that lower-valuation stocks outperform higher-valuation stocks? 

This analysis is factually accurate, but there are two things to consider.

The first is data in the aggregate, not about any individual stocks.

The best-performing stocks of all time – where a single winner can change your financial future are RARELY cheap. 

Investors pay for growth and quality. If you want to make real money as a long-term investor, you want to identify and buy the best quality and growth for the long term. Then HANG ON!

Why, then, do valuation metrics show good performance as an indicator?

The reason is that valuation itself doesn't matter. Still, the valuation relative to history is a good gauge of investor expectations…

If a stock has moved to the high end of its valuation range, it results from the company's positive performance. This raises investor expectations along with the stock price and valuation.

This can leave the stock vulnerable to disappointing these investors if those high expectations are unmet. When they are disappointed, they sell the stock, which goes lower.

Quite often, very low multiple stocks have a low multiple because they have disappointed investors' expectations. 

This is not always the case, though; you should be just as careful with low multiple stocks as with high multiple stocks. Often, stocks trade at a low multiple or "cheap" for very good reasons.

With low expectations, however, you have an excellent setup to beat those expectations and lead to increased investor excitement. This can drive the stock price higher…

One of our favorite examples of the role of valuation is the stock of Amazon.com, Inc. (NASDAQ:AMZN).

Here is a chart of the P/E ratio for AMZN going back to 2002. The green bars show the range of P/E during that period, and the white line is the stock price.

Across this period, the stock has had an average P/E of 197x (!) and a media PE of 92x (!). 

Given that the overall stock market average P/E has been closer to 20x, AMZN stock has certainly NEVER been cheap!

Here is the chart of the stock since 2002…

The stock is up an astonishing 25,000%! Valuation didn't seem to matter at all for AMZN stock…

Obviously, we are picking one of the most significant companies of all time. Still, the point remains valid – focusing on valuation as the primary driver of stock performance is not a suitable method.

Valuation can be a good measure of investor expectations but not necessarily of what is or is not a good (or great) investment.