How Much Should Investors Worry About Valuation?

Have you ever seen an impressive, high-growth business, but were afraid to pull the trigger because the stock looked too expensive? This is a common mental hurdle that is difficult for growth investors to overcome. In this Fool Live video clip from our Nov. 2, 2020 Industry Focus show, host Jason Moser and Fool.com contributor Matt Frankel, CFP discuss how much valuation should matter to investors. 

Jason Moser: Well, there's a good question, a good statement in a question here from Nadia that I thought would be fun to entertain for a minute. Nadia says, "Hi, I'm glad to hear both of you say the price does matter. I'm a stock advisor and a Rule Breaker member, and stocks seem very expensive lately. I don't dare buy any of the wrecks. I find it quite difficult with my level of knowledge to know what is a decent price or not, any advice?" Nadia, I'm glad you asked that question. Thank you for that. I think that it's an important question that deserves attention, and the tricky part about valuation, and I'm sure Matt will agree is, it's just as much art as it is science. With that said, there is some "science", to that, right? You're plugging some numbers to try to get an idea of what this company maybe worth, and why the market's willing to pay whatever it is willing to pay for it. The tough part with valuation is that it's not always apples-to-apples. There's different ways to value different companies. I think that's where it can become overwhelming. But we've always viewed it in my 11 years here as an investor with the Motley Fool, is you're trying to get as many tools in that tool box as you possibly can. As many tools in that investing toolbox of yours is you possibly can to be able to look at companies and get a better idea of what they might be worth, and whether evaluation makes sense or not.

Matt Frankel: I got to be honest, there have been a few recommendations by stock advisor and Rule Breakers in the past few months, and I've looked and immediately been like, "Look at that valuation, that's terrible."

Jason Moser: Yeah.

Matt Frankel: Then the stock goes up by 30 percent.

Jason Moser: Right.

Matt Frankel: I mentioned focus on quality. Quality is the more important thing. Buying a quality business is more important than buying something that's cheap. At the same time, when I say valuation matters, you want to see some path to profitability become one company that we talked about a lot of, not in this podcasts is Fastly (FAST 0.59%), the Internet, the computing company. They're not making a ton of revenue. If you look at like a price to sales, their valuation looks completely ridiculous. The company is growing at a crazy rate.

Jason Moser: Well, it was.

Matt Frankel: It's still growing pretty, they lowered their growth forecast from 46 percent to 40 percent. That's still impressive in my opinion.

Jason Moser: They have a big customer that apparently is not going to be giving them as much of their money as they used to.

Matt Frankel: But that said, even if that happens. They're still growing at a 40 percent annualized rate. Which point being, a growth rate like that can justify a seemingly crazy valuation because it's a good business.

Jason Moser: Yeah.

Matt Frankel: Don't necessarily avoid recommendations because of the valuation. Avoid recommendations that don't fit into your investing style or something might be a little too risky for what you want. Or if you're going to buy this and you're going to be constantly checking your portfolio, not being able to sleep at night, that's another thing. But don't buy something just because you think the valuation's too high because I can tell you in my 10 years at The Motley Fool, that every time I said the valuation that on a recommendation is too high, at almost every time, it goes through the roof. I am the guy who called Amazon (AMZN -1.65%) too expensive at 300 bucks.

Jason Moser: You've learned some lessons as you go along. Like Amazon, I was lucky enough to get into that one back in 2010. Even at that time, people just saying, "It was just ungodly expensive. How could you do that?" I'm sitting on some absurd number of times over my money because I bought some shares and left it alone. Shopify (SHOP -2.37%)I think is another good example of one. When I recommended Shopify and one of my services a couple of years ago and I made a note at the time, I said, listen, I know this valuation may seem a little bit scary and I'm with you. It is a little bit scary. What I tend to do when I see a valuation like that, if it's a business that I like, I understand the business I believe in its future and I feel like there's an opportunity there, I will buy in small lots of shares, I will not invest all of my money in that business at once. What that does, it helps you spread that out a little bit. Perhaps you'll be able to take advantage of some opportunity if the stock price does dip for whatever reason. If it doesn't dip well, then at least you have a stake in the business and you've got some of it. You can always add on the way up. That's like, I say it all the time. That's, I think, probably the most valuable investing lesson I've gotten from David Gardner ever is just get comfortable with adding to your winners. There's a lot to be said for being able to do that. It is not easy and I think as long as you are able to keep a diversified portfolio, where you're not pegged to just all growth stocks. Have some stability in there, if you have some stability, that'll enable you to take some small positions and some of these high fliers that may seem expensive. As Matt was saying, we've seen plenty of those stocks that seem expensive, just keep on going and they go typically because they often times are good businesses.