If you buy and hold a quality stock for the long term, you expect to earn a good return. But often, I see investors dismiss valuations because the argument is that everything will sort itself out in the long run -- and that can be a dangerous assumption.
If you buy a stock at a high valuation, it can be difficult to earn a good return. And in some cases, you could even face the risk of a sell-off due to that heightened valuation.
Microsoft (MSFT +0.02%) is a great example of this, because it might surprise you to learn that holding the stock for more than 20 years has actually been a worse move than owning it over a much shorter time frame.
While long-term investors have made out well from owning the stock, those who prioritized valuation and bought the stock at a more reasonable multiple made out much better than those who didn't.
NASDAQ: MSFT
Key Data Points
Microsoft in the dot-com bubble
Microsoft has been a top technology stock for decades. But even good stocks can become overvalued. Here's a look at Microsoft's price-to-earnings (P/E) multiple back in the first few months of 2000, right before the big dot-com crash.
MSFT PE ratio; data by YCharts.
At the start of 2000, it was trading at more than 70 times earnings. The danger with paying a high price for a stock is that it can take a long time for the underlying financials to catch up since that inflated valuation has a lot of future earnings already baked into that price. You're effectively paying for growth the company hasn't achieved yet.
Today, Microsoft isn't anywhere near those inflated multiples, but it's still not cheap, either, trading at more than 40 times its trailing earnings.
Investors who bought in 2016 outperformed those who bought in 2000
For investors who bought at the start of 2000 and who ignored the stock's extremely high valuation, they endured a costly dot-com crash. Here's a look at what a $10,000 investment in Microsoft's stock back in 2000 would be worth today.
You see a bit of a dip in the price. And in the end, you would see your investment grow to around eight times its value by today. You still end up with a great return by holding on for the long run.
But now, consider what your returns would be if you invested in the stock in 2016, when Microsoft was trading at a P/E of around 39.
Your investment would actually be worth more now versus the investor who bought shares back in 2000 and incurred a big decline. While looking back over 20 years, it looks like nothing more than an insignificant blip in the stock's overall performance, it did have a significant adverse effect on the stock's overall gains.
Investors should never ignore valuations
There are different norms for different industries when it comes to earnings multiples. In tech, investors are accustomed to paying more than the 10 to 15 times earnings they might pay for bank stocks or consumer goods stocks.
But that doesn't mean that paying an obscene multiple is always justifiable and likely to lead to a good return as long as you hang on long enough. Microsoft is a good stock, but paying an egregious multiple for the stock in 2000 proved to be a costly mistake for investors.
Even today, at 40 times earnings, it's a bit pricey since a lot depends on how it grows its business as it focuses on artificial intelligence. But it's still nowhere near the incredibly high price it was at in early 2000.
While you shouldn't necessarily try to time the market, it's important to always consider valuations. There are many good growth stocks to choose from, and by factoring in valuations, you can find the best ones to buy. Today, Microsoft is still a good buy for the long term because it has new opportunities to pursue, but there could also be better-priced options to consider.
