Here's an interesting question I received from a Fool reader: "I'm intrigued by stocks that have recently skyrocketed, but my broker says their prices are too high. What do you think?"
My answer is that it all depends on your expected holding period and what you think is a fair price for the company, considering its growth prospects. Imagine the Dodgeball Supply Co. (ticker: WHAPP). Let's say its stock price has tripled lately to $60 per share. According to your research and calculations, a fair price for the stock is $45 right now, $60 next year, and $85 the following year. You expect robust growth to continue for a decade or so.
Given this scenario, the stock price of WHAPP does seem to have gotten ahead of itself. But what if, due to high quality and persistent demand, the stock always trades at such a premium? Some stocks, such as Wal-Mart
If you just want to hold a stock for a few months or even a year or two, you should steer clear of those trading at rich valuations. But if you're a Fool with long-term intentions, you could justify buying now, if the price is well below where you expect it to be in a few years. The downside with this approach, though, is that your expectations may be... wrong. And so you're proceeding without much downside protection.
That's why another breed of investor -- the value investor -- bypasses steeply priced stocks, preferring to invest only in stocks that trade well below what they're currently estimated to be worth. This is a less risky approach, offering a margin of safety. If a stock is trading for $30 per share and you think it's currently worth $15 more, you'll make some money even if it only increases half of that in the time you hold it. Of course, there's no guarantee that something won't go terribly wrong even with a stock that seems cheap -- and indeed, many times various stocks are selling at very low prices for good reasons.
This all points to one conclusion: Smart investors should take the time to continually learn about investing. Decide which approaches and strategies make the most sense for you. See what works for you and tweak your system as needed. Learn what the masters say and do. (Perhaps even check out what stocks Fools are recommending -- and, importantly, why they're suggesting them.) One master who has always been happy to offer his wisdom is Warren Buffett -- read his annual letters to shareholders sometime and you'll gain some insights and chuckles at the same time.