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Should You Pay a Premium for a Great Stock?

By Michael Hooper - Updated Mar 7, 2017 at 4:11PM

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Don't be afraid to overpay for a stock with a history of rewarding shareholders. Winning stocks tend to keep on winning.

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 (D -0.39%), Hershey (HSY 0.83%), and Boston Beer (SAM -0.85%) 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:

NameForward P/EPrice/SalesPrice/BookDividend 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.

Michael Hooper owns shares of Boston Beer, Dominion Resources, and The Hershey Company. The Motley Fool recommends Boston Beer and Dominion Resources. The Motley Fool owns shares of Boston Beer. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

The Boston Beer Company, Inc. Stock Quote
The Boston Beer Company, Inc.
SAM
$375.87 (-0.85%) $-3.24
Dominion Resources, Inc. Stock Quote
Dominion Resources, Inc.
D
$82.57 (-0.39%) $0.32
The Hershey Company Stock Quote
The Hershey Company
HSY
$227.11 (0.83%) $1.87

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