Valuation is a Measurement of Soundness and Not the Primary Total Return Producer: Part 1


Much of what I write about is related to the importance of valuation in one way or another. I do this, because I am a fervent believer that one of the most important metrics that investors should be considering before investing in a stock is the relative valuation of the shares they are purchasing.

To summarize what I’m saying, if they are interested in investing in a company and discover that the current market valuation is very high, I contend they should either wait or look elsewhere for better valuation. In contrast, if valuation is fair or sound, then I contend they could comfortably go ahead and make the investment. Finally, if the valuation is significantly undervalued, I contend they might consider investing aggressively.

However, before they even get to that step, they should be investigating a company that meets their specific goals, objectives and risk tolerances. This is vitally important, because valuation is not the final say in the rate of return they can expect from their investment in a given company. Instead, valuation is primarily a measurement of soundness or risk.

Although it is an important component of the possible rate of return they might achieve, it is not the primary driver. Once sound valuation is identified, from there the primary driver of future returns will be the growth rate of the earnings and dividends (if any) that the company generates going forward. Investing when valuation is sound empowers the investor to safely earn a rate of return that is commensurate with the operating results that the company they invest in produces in future time.

With this article, I intend to demonstrate the importance of fair valuation and how it mitigates risk, and how it can be utilized to assist in evaluating the future rate of return you can expect from investing in a given stock. This is consistent with the importance and utilization of the P/E ratio as a measurement of soundness or fair value. In my experience, both the relevance of fair valuation and the importance of the P/E ratio are grossly misunderstood by many. With this article, I intend to bring some enlightenment and better understanding of both.

Choose Common Stock Investments That Are Appropriate to Meet Your Goals or Objectives

There are many types of common stock investments available to investors. In other words, common stocks come in all sizes and shapes with each possessing their own individual characteristics. There are companies (stocks) that grow at very high rates and others that grow at moderate rates and some that grow very slowly - and everything in between.

Consequently, if you’re an investor looking for maximum capital appreciation, a company with a slow rate of earnings growth will not fit your needs. In contrast, if dividend income is what’s most important to you, then you want to look for companies with consistent records of paying a dividend and/or growing that dividend over time. Additionally, you also have the consideration of yield in combination with growth. Some stocks offer high-yield and low growth, some offer moderate yield and moderate growth, and some even offer high growth with very low yield. Of course, there is also everything in between.

The trick is to understand the characteristics of the common stocks you are considering, and most importantly, making sure that they are suitable to meet your own specific needs, goals and objectives. In other words, I believe it’s imperative that investors recognize what the potential capability and specific opportunities that any stock they are considering might be capable of giving them. Not all stocks are the same, and not all stocks fit in every portfolio.

However, in order to choose the common stocks to meet your own goals and needs, you also have to be realistic and understand a couple of important facts. For starters, you cannot solely depend on a company’s historical track record of growth. You must be cognizant of the fact that earnings growth rates change, and as a general statement, the bigger the company gets the harder it is for it to continue growing at high or above-average rates.

This last statement is conceptual in that there can also be companies that are growing slowly, but can be expected to continue growing at historical rates. In other words, what I am suggesting is that you understand as comprehensively as possible what the companies you are considering are capable of generating on an operating basis going forward.

Although you cannot invest in the past, you can learn from it. Moreover, it also pays to be realistic and even conservative with your expectations of the potential of any company you are examining. Again, this is important because you can only invest in the future potential of any common stock you are considering. Whether your expectations turn out to be accurate or not, your total rate of return will end up being a function of the actual operating results the company produces in conjunction with the valuation you initially paid to purchase those results.

Many times in the past I have stated that measuring performance without simultaneously measuring valuation is a job half done. However, I would like to modify that statement a little bit in order to make it more relevant. Measuring performance without simultaneously measuring valuation in conjunction with growth potential is a job half done.

I believe that when an investor understands the importance of valuation, and possesses a reasonable expectation of the growth potential of the companies they own, they are empowered to make safer, better and more profitable long-term decisions. I call it investing with your eyes wide open.

In order to illustrate these principles more clearly, I offer the following examples illustrating how growth and valuation impacts long-term rates of return. However, I am not capable of presenting every possible situation or option. Therefore, I will only be offering a few disparate examples in order to illustrate as clearly as possible the principles underlying the primary thesis of this article.