Should You Pay a Premium for a Great Stock?

A company with a steady history of rewarding shareholders may carry a premium stock valuation compared to its peers. Such stocks tend to perform well in the market but are ignored by critics who think they are overpriced. Should you buy such stocks? The answer is yes, if you have a long-term outlook. Warren Buffett's partner Charlie Munger influenced Buffett's investment philosophy to include investing in high-quality businesses for the long term. Munger convinced Buffett that sometimes it's worth paying a premium for a great business.

Let's take a look at three stocks that are trading at a premium to their peers. Dominion Resources (NYSE: D  ) , Hershey (NYSE: HSY  ) , and Boston Beer  (NYSE: SAM  ) boast projected growth in sales and earnings. They're leading businesses in their fields -- Dominion in energy, Hershey in confections, and Boston Beer in craft brewing. This table compares them to major competitors with regard to several key metrics:

Name Forward P/E Price/Sales Price/Book Dividend Yield
Dominion Resources 17.92 2.65 4.25 3.76%
Consolidated Edison 14.6 1.3 1.4 4.5%
Westar Energy 14.18 1.64 1.3 4.5%
Hershey 24.6 2.84 18.3 2.13%
Smucker 18.37 1.92 2.22 2.16%
Kellogg 15.86 1.47 8.51 3.06%
Boston Beer 42.72 4.57 11.59 N/A
Anheuser-Busch  20.1 3.86 3.27 2.29%

Source: Charles Schwab Research; Yahoo! Finance.

High-value voltage
Dominion
trades at a premium to comparable electric-utility holding companies. However, this premium is warranted based on the company's long-term earnings-growth prospects, multiple energy-generation sites, huge natural-gas holdings, stable operations, and above-average financial strength. Much of the company's business is a regulated monopoly; for example, it is the only source of electricity in parts of Virginia. I project average annual earnings growth of 5% to 6%. The U.S. Department of Energy recently approved Dominion's Maryland Cove Point LNG facility for natural-gas exports to non-free-trade-agreement countries.

Is this chocolate too rich?
Hershey trades at a forward P/E of 24.6 -- higher than the five-year average range of 17.5 to 24.2. The current price-to-sales multiple is much higher than those of competitors J.M. Smucker and Kellogg. Hershey warrants a premium based on its dominant position in the chocolate confectionery business, growing sales and EPS outlook for this year and next. Management projects full-year earnings growth of 14%. 

Hershey had a 43.3% market share in the U.S. chocolate market at year-end 2012, ahead of Mars/Wrigley at 30.7% and Nestle at 5.9%. In the U.S. total confectionery market,  Hershey's share was 29.9% compared to Mars/Wrigley at 30.8%. Risks Hershey faces include reduced cocoa supply and rising prices. I believe Hershey has the ability to raise prices and still retain customers. At an average of $1.50 per chocolate bar, Hershey could likely raise prices 10% without turning buyers away.

Giving new meaning to "premium beer"
I've never seen Boston Beer trade at such high multiples as it does now. Anheuser-Busch InBev is cheap in comparison, but A-B InBev is a fully mature company, whereas Boston Beer is a craft-brewing leader with only 1% share of the American beer market, leaving plenty of room to grow. Boston Beer is valued at a premium because the company's sales are growing 15% to 20% annually -- a trend I expect will continue due to rising demand for its many products, including Angry Orchard Cider and seasonal beers such as Octoberfest.

The company reported second-quarter 2013 net revenue of $181.3 million -- an increase of 23% over the same period last year -- mainly due to core shipment growth of 21%. Net income for the second quarter was $19.7 million, or $1.45 per diluted share -- an increase of $5.4 million, or $0.39 per diluted share, from the second quarter of 2012.

Stocks trading at premiums get hammered if they don't meet analyst expectations -- for example, Boston Beer stock dropped 15% in two days after first-quarter earnings disappointed, though the stock recovered handsomely after second-quarter results were announced. 

Still, there is a case for owning stocks valued at a premium. As Motley Fool co-founder David Gardner says, winning stocks tend to keep on winning.

The bottom line
I say own the best companies; their stocks tend to perform well over time. Dominion, Hershey, and Boston Beer are dominant businesses with projected growth in sales and earnings. Buy stocks at a premium if you have a long-term outlook. Don't panic if the stock dips in price; instead, consider buying more.

The best way to invest
The Motley Fool's free report "
3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


Read/Post Comments (6) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 18, 2013, at 8:18 AM, AnsgarJohn wrote:

    Read "Snowball" Munger and Buffett did NOT! pay a premium for Coca-Cola they bought went the stock price tanked.

    Buffett had admired the company for years but never bought because it was too expensive. That's disciplined investment.

    He hasn't bought any Coca-Cola since then either.

  • Report this Comment On September 18, 2013, at 8:27 AM, AnsgarJohn wrote:

    Buffett refused to pay a premium for Coca-Cola. He had to wait for many years until the stock price dipped low enough. Interesting method with options as well. Read the story.

  • Report this Comment On September 18, 2013, at 8:41 AM, daveandrae wrote:

    No.

    Nuff said

  • Report this Comment On September 18, 2013, at 11:24 AM, ScoopHoop wrote:

    Thank you for your comments. We have made correction. Buffett has paid a premium for some businesses, no doubt. BNSF was trading at 79 to 80 per share when he said he would pay 100 per share for the whole business. That certainly was a premium above the prevailing stock price.

  • Report this Comment On September 18, 2013, at 11:31 AM, TMFHousel wrote:

    Here's what Munger said on the topic:

    "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result."

  • Report this Comment On September 18, 2013, at 11:39 AM, ScoopHoop wrote:

    Excellent quote.

Add your comment.

DocumentId: 2607237, ~/Articles/ArticleHandler.aspx, 7/28/2014 6:05:29 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement