FOOL ON THE HILL: An Investment Opinion
Dangers of Overpaying

Investors who plunge into stocks with no regard for share price put themselves in the same camp as those who hold only for the short term. How so? Both are betting more on investor enthusiasm than business fundamentals.

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By Richard McCaffery (TMF Gibson)
October 19, 2000

In the last two weeks, Fool writers Whitney Tilson and Brian Graney have talked about the dangers of paying too much for a stock.

Here are the links to both the stories. I encourage investors to read them.

Great Company, Bad Stock
Perils and Prospects in Tech

Valuation is one of the most challenging aspects of investing, one of the most controversial, and one of the toughest areas in which to be accurate. Nevertheless, I'm going to throw in my two cents.

I see similarities between paying too much for a stock and short-term investing. Sacrilege? Maybe, but the stock price of a grossly overvalued company is based more on investor enthusiasm than business fundamentals. This is what short-term investing is all about. You try to guess how other investors will view the stock in the coming months and move accordingly.

As a result, investors who buy stocks regardless of price are at the whims of the market rather than business basics. Some of these risks are eliminated if the investor holds the shares of an excellent business for the long haul -- there is no doubt about that -- but not all of them. The more a company's share price floats above the present value of its future cash flows, the more such an investment is speculative -- regardless of how long the investor's time horizon is.

We're perhaps seeing the effects of this in our own Rule Maker Portfolio (which I help manage). On October 10, Yahoo! (Nasdaq: YHOO) reported stellar sales and earnings growth, yet the stock has fallen 37% to about $52 per share in the last week. There's nothing to merit this kind of sell-off, given the company's business performance this year. Yahoo! has treated investors to the same steady growth in fundamentals: higher revenues, income, and free cash flow. Revenue growth is declining, but this isn't a new trend.

Look at Yahoo!'s year-over-year revenue growth for the last nine quarters:

      2000  1999   1998

Q4    ?     120%   237%
Q3    90%   135%   283%
Q2    110%  186%
Q1    120%  240%
Everyone keeps looking for a business reason, but there isn't one that can explain the vaporization of more than $15 billion worth of market value in one week, or more than $100 billion this year. Are online advertising revenues drying up? Will a new advertising pricing model emerge that renders Yahoo! significantly less profitable? Is the fast-growth period over? Has Yahoo! failed to execute in some way for which it's now being punished?

Not that I can see. Anyone who tells you they have a fundamental business reason for adjusting Yahoo!'s market value way down probably isn't playing it straight. What happened is that enthusiasm cooled and the laws of business physics began realigning the share price to levels that make more sense simply because they're much lower.

For the record, I consider Yahoo! just as great a company today as it was a year ago, only now it trades at about 65x trailing free cash flow (FCF) compared to about 426x trailing FCF last October. But, can shareholders make an argument that last year's valuation is a more accurate representation of Yahoo!'s intrinsic value than today's? I wouldn't take that bet.

As I said, I'm upbeat about Yahoo!'s prospects. Its business efficiency and market status are worth a healthy premium. I just wouldn't pay 65x trailing FCF to go along for the ride. (Many investors whose opinions I value disagree with me, by the way, but that's where I stand.)

That's why I have a problem with the buy-at-any-price mentality that uses the following kind of argument: Say I buy shares of Company A at $10 per share and it increases to $110 based on the strength of its fundamentals, giving me a 1,000% gain. Does it matter if I paid $20 per share or $30, reducing my gain to 450% or 267%, respectively? In this context, price isn't really a factor. I'm giving up outsized gains if I'm willing to buy at $30, but the serious error in this scenario is not buying at all.

The problem with this thinking is that investors are fortunate to have one or two bona fide 1,000% winners in a lifetime. Therefore, determining the price I'm willing to pay for every stock by viewing it through the lens of a perfect outcome, say a 500% return, makes little sense. I need more conservative tools with which to select investments.

So, I look for a combination of factors: a reasonable price relative to future cash flows, one that gives me at least a slight margin of safety; excellent growth prospects in a business I understand; and a management team that's proven itself.

The difficulty in all this, of course, is that quality stocks are often exuberantly priced. Investors have the best chance of compounding solid returns over the next 10 or 20 years by aligning their interests with those of the best companies available at fair prices.

Therefore, it's critical for investors to get past the idea that the way to accumulate wealth in the stock market is to buy stocks of low quality simply because they're available at attractive prices. What's the right price for a piece of junk?

But it's dangerous to swing too far out on the quality vine so far that you're insensitive to dizzying heights. Price plays a role in every financial decision I make. It matters in the world of investing, too.

Speaking of price, think you know how to save priceline.com (Nasdaq: PCLN)? Appoint yourself CEO and participate in our Save priceline.com contest! We'll award prizes for the most creative, funny, and Foolish entries.

Have a great day.