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Not at all. In fact, it could be that the $20 per share stock is vastly more expensive than the one that is at $50, both on a current and a forward valuation basis.
For the first way, we look to the "Price to Earnings ratio," or P/E. For example, Pfizer (NYSE: PFE) shares currently trade at $34 1/2, while DuPont (NYSE: DD) costs $61 per share. But on the current value basis DuPont is cheaper, as its P/E is 5 compared to 48 for Pfizer. By this comparison, Pfizer, though its share price is lower, is more expensive than DuPont.
"So," you say, "I should only look for companies that have a low P/E and buy those, because they're cheaper."
Not necessarily. Because the second type of valuation uses the future, the unknowable, to gauge how a company should be priced. You see, a stock is priced upon the current value of its estimated future earnings. This means that we should look not so much to the P/E, which, by nature, is a ratio of current price to past earnings. Instead, we should look more to the P/E as it compares to the company's rate of future growth.
A company with a low P/E that is losing market share may not be much of a bargain, since it has been valued so low for a reason. At the same time, even though Cisco's (Nasdaq: CSCO) P/E has not been below 80 at any point in the past five years, I doubt that there are too many people who bought it five years and 1800% ago who feel that they did not get a bargain. Just so, the people who bought Bethlehem Steel (NYSE: BS) five years ago thinking they were getting it at a bargain price instead bought into a stock that has lost money in a time that has seen the S&P 500 increase by 400%. In hindsight, it wasn't much of a bargain, as it has lost more than 60% of its value while the eternally overpriced Cisco has continued its rampage. To drive this point home, check out this chart which compares Cisco, Bethlehem Steel, and the S&P 500 over the past five years.
But this does not mean that valuation is unimportant. It is of crucial importance, taken in context. There are millions of people who refused to buy into (or bailed out of) some of the great growth stories of this past decade because the companies were "too expensive." There are also those of us who bought into companies with depressed share prices because they represented, in our minds, a compelling value. In either case, a thorough evaluation of the quality of the business may have helped the investor make a more prudent and beneficial decision.
Look at it this way: Our Rule Makers don't have that much in common except that they are dominant players in their respective industries. In each case, but particularly with Microsoft (Nasdaq: MSFT), there can be no doubt that Rule Makers are and have been valued quite highly relative to their current earnings for some time, certainly from before we selected any of them for our portfolio. These companies had a wide range of P/Es when we selected them, and they still do today. Interestingly though, the Rule Makers that had the highest P/Es -- Cisco and Microsoft, plus Yahoo! (Nasdaq: YHOO), which was not yet profitable and thus had no P/E -- when we originally purchased them are also the ones that have given us the highest percentage returns to date.
This is the key component to long-term buy-and-hold investing. You must buy companies that are of the highest quality, the ones that have the best chance of providing sustainable, high business returns over the course of a decade or more. If you can find these companies, and are committed to owning them for the long-term, then the price at which you buy almost doesn't matter.
I say "almost" because this is a key factor where the Foolish investing method is misunderstood. We do not believe in buying companies absolutely regardless of price -- not the best companies, but more especially not the lesser ones. There is a certain margin of safety involved when buying an excellent company at a price that is less than its fair value. But what price is that? Determining a company's intrinsic value is, unfortunately, not fully knowable, as it requires the investor to make some assumptions about future growth.
Fact is, calculating a company's fair value requires a lot more guesswork than determining a company's quality. A quality Rule Maker exhibits high profit margins, expanding opportunities, and a solid balance sheet, among other attributes listed in our Rule Maker Criteria. Regardless though, buying a top rate company at nearly any multiple to current earnings is better than buying a marginal company at nearly any price, as the Cisco and Bethlehem Steel example shows.
In fact, I would say that the single best gauge for an investor's success is the quality of companies he or she holds. Not entry points, not being a growth or value investor, not getting in at the IPO, not technical analysis, not even the position of Mars while it is in retrograde. The single most important determinant for long-term appreciation of investments is the quality of companies invested in. After all, the companies providing the highest returns to investors over this century, Coca Cola (NYSE: KO), General Electric (NYSE: GE), Wal-Mart (NYSE: WMT), Home Depot (NYSE: HD) among others, all happen to be some of the largest, best run companies on the planet. Each of these companies may have periods of years in which their stock prices remain in place, yet have been considered "overvalued" for that entire duration of time.
The question of quality should be the absolute first determination for the Foolish investor in regarding any company for investment consideration. Only once the quality has been determined beyond the shadow of a doubt should one worry about valuation. Great companies will always seem expensive in relation to others, but in some ways that overvaluation is the very thing that SHOULD attract us to the stock. A company only becomes expensive when more people are willing to buy it than are willing to sell it. Wouldn't you want to own that kind of company, a maker of the rules, in your portfolio?
Fool on!
Bill Mann
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