This Foolish 8 classic originally ran Feb. 27, 2001.
Over the past few weeks, we've attempted to outline what it takes to invest successfully in small companies for the long term. We've already emphasized the importance of looking for three "good" things: good business areas, good companies, and good management. The fourth and final "good" thing, buying shares in a company at a good price, has been saved for last. This ordering was intentional. For the individual investor, the question of what price to pay for an ownership share of a business is the last question to ask.
Of course, this is not to say that paying attention to price is unimportant when investing for the long term. Not paying close enough attention to the price being paid for a company's shares is one of the most common errors investors make, and probably always will be. But focusing too much on price and buying shares in a business based on a low price alone is another common mistake. Keep in mind that if a firm's shares are priced like the company is going out of business, perhaps it is going out of business. As a former Fool writer once put it concisely, though not very mannerly, "Cheap crap is still crap."
If the small-company investor follows "the four goods" in order and finds a good company in a good business area with good management, then worries about buying "crap" can largely be dismissed. It's worthwhile to establish whether a company is a high-quality business first before looking at the stock price, in the same way that it pays to figure out if a used car runs well before considering its price tag.
In the end, what you find out about a business' quality will greatly influence what constitutes a "good" price for that company's stock. Not all companies are created equal, which is why investing in stocks based solely on price and without any consideration of underlying business quality is not a smart policy. The truly great companies that will compound in value over a number of years are simply worth more than companies with just average characteristics. That's true regardless of the type of company you are investing in -- big or small, industry leader or perennial second banana.
It has been argued in this space before that price is so important, it should actually be considered a fundamental in a long-term investor's eyes. Nothing determines the ultimate return from a stock investment -- or any other investment, for that matter -- more than the price paid to acquire the investment in the first place. In all other human pursuits, getting the most value for the least price is considered rational behavior. It is no different with stocks, except for in the stock market prices change every single trading day.
In the end, the broad and often murky issue of stock valuation boils down to one thing. Some investors call it "fair value," others prefer the term "reasonable price." Whatever the lingo, the basic idea is the same: "Am I getting a good deal for this stock?"
Such a simple question, yet not an easy one.
It is at this point that investing truly becomes an art, as there is no magical method for determining a company's fair value. There are shortcuts and rules of thumbs, such as buying companies with low price-to-sales ratios or stocks with price-to-earnings ratios less than the firm's expected future growth rates. But these are just tools; they do not determine fair value for any company in and of themselves. A good determination of a company's fair value sprouts from a solid understanding of the business, which allows for setting realistic expectations about what the future may hold in store.
If you are unable to determine a fair value for a company within a reasonable degree of confidence, then you are not ready to invest money in that stock. Without knowing what the company is worth, how will you be able to tell if you are getting a good deal at the current market price? On the other side of the coin, how will you be able to tell if the same company happens to become ridiculously overvalued down the road and it makes sense to sell?
Finally, how else will you be able to muster the courage to stick with a stock and keep a long-term perspective amid the day-to-day market gyrations that are almost a given with fast-growing small companies? A good estimate of fair value is the keel that will keep your long-term investment boat from cap-sizing when the stock market waters get rough.