Drip Portfolio Report

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A Letter to Jeff
Should I care about valuation?

by Brian Graney ([email protected])

ALEXANDRIA, VA (March 16, 1999) --
Dear Jeff:

I hope this letter finds you doing well. I just wanted to drop you a short note concerning last week's column on Price vs. Value, which I thoroughly enjoyed reading. However, I must admit that as someone still trying to learn about how to buy my first Drip, it did stir some questions in my mind.

Specifically, your column renewed a question that has occupied my young investing mind for some time. It is a question of such import that I have heard entire fortunes have been created and destroyed based on an individual's response. It is a question I believe lingers in the minds of young investors everywhere, like the memory of a past love unresolved that is stored among the varied contents of a person's mind, reappearing when the wind blows cold and the night draws long...

Wait, how did that last line get in there? That's the opening phrase from the romance novel I wrote while you were in France a few months back. It is tentatively titled "The Lonely Foolish Heart." You can look for it in FoolMart and on the shelves of an airport gift shop near you soon.

Putting that aside, Jeff, here's what has been bugging me for the past few days: "Should valuation matter for a long-term Drip investor?"

This is what you said about valuation last week, referring to Drip investing:

"Using dollar-cost-averaging, you'll buy the same stock at many prices over several years. So within reason, the current valuation isn't very important to you as long as you find a moderately successful long-term investment."

I've added the italics to emphasize that you stopped short of saying valuation doesn't matter at all. But as a new investor still learning about how to place a fairly accurate price tag on a company before buying its shares, your thoughts did get the wheels of my mind turning on the issue of valuation. How important is valuation, really?

I understand the advantages of dollar-cost averaging your way into stocks and building a substantial holding in a company over time, which are the cornerstones of Drip investing. However, in choosing a company for my first Drip, shouldn't I also consider what the company's underlying value is? As you know, I don't want to invest my money in a company whose ultimate value is currently overstated by Mr. Market, thus running the risk that the company's share price will decline over the next decades as the real value of the business becomes more fairly expressed. How can I prevent this from happening without giving at least some thought to the question of valuation before investing?

For young Drip investors like myself, the valuation question can be about as frustrating as a tough Final Jeopardy question, where the category is "History of the Cabbage" or some other arcane subject. Even finding a definition for what one means by "valuation" is confusing. Is it, as it was explained somewhere, the discounted present value of the sum of all of the future cash flows a business can generate? Or is it, as you said in your column, "of the moment?" What should a new investor do -- focus on the future or focus on the present?

On a more basic level, shouldn't investors be interested in looking at industries that Mr. Market may have beaten-up unfairly in the short-term, such as the oil and gas industry we are currently examining? Is this type of contrarian thinking Foolish or just plain folly for a young Drip investor?

In my mind, the ultimate 20-year to 30-year Drip investment opportunity for a young investor would be in a company whose real value is not being fully recognized today, but whose share price rises gradually over time as that real (some may say intrinsic) value is incrementally recognized and factored into the company's market price. This is the way I have always approached investing in a company, whether through Drips or through a lump-sum purchase of shares.

In short, should I just buy what I know? Or should I buy what I know is undervalued?

Of course, I'm still learning this stuff, so my views on the subject of valuation are not set in stone. But I think it is important to have a clear, personal view on this topic before buying my first Drip, which I am close to doing. Hopefully, this letter will stoke the coals a bit and inspire some more discussion about the topic on the Drip Companies or Drip Basics message boards from yourself and from other Fools as well. I'm looking forward to hearing everyone's answers to the many questions this new investor has posed.

Your friend in Foolishness,

Brian
[To discuss these columns, please visit the Drip Companies message board on the Web.]

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