Why Valuations Matter
Why you should always watch what you're paying for a company
Valuations are now, have always been and will always be the single most important thing when investing.
You can own the best and most profitable company in the world, but if you paid too much for it then you will lose money.
This might seem a controversial view in an age where we have Financial Advisors saying things like this:
I think it’s clear, both from my tone in this article, but also from my previous articles that I disagree with Mr. Kudla, and with everyone else who exposes similar sentiment.
That being said, Is that disagreement valid? Based on the facts? Or is it just an emotional rejection?
Let’s talk about that!
Do valuations truly matter?
The short answer is Yes, they do.
At the end of the day the way that investors market their returns from owning a company is through dividends and share buybacks.
The returns you get from an investment is a direct result of the dividends, and the companies increasing ability to raise and pay them.
This is confirmed if we look at the historical returns:
What this means is that the underlying value of the companies you own is essentially the only factor that determines their return.
The corollary to this is that your specific total return will be the difference between what you paid for the company, and what the company will return.
This means that the only way for an investor to make money over the long term without divesting himself of the company is to pay less for the company than they will receive in dividends.
Is that it?
No, of course not.
Just because on average the total return is explained by the underlying fundamentals of the company doesn’t mean that there are no other ways of making money.
There are arbitrage strategies where you exploit differences in demand, such as the ones employed by authorised participants in ETFs.
There are High frequency Trading strategies, and other market maker strategies.
There are momentum strategies that try to ride high flying stocks when they are running up, and leave them when they turn sour.
All of these strategies exist, and can be profitable, some of them incredibly so.
The problem with all of these strategies is twofold:
First, most of them are inaccessible to the everyday investor.
Second, they often involve competing with a myriad of others who are conducting the same strategy, which drives down returns.
Additionally, many of these strategies are Zero Sum Games, for anyone to “win” that means that there is someone on the other side of the trade that lost. This too drives down potential returns, and increases losses.
Ultimately you can invest in many different ways and make money, but if you want to have the trade-winds at your back, the average investor should aim to find valuable issues being sold at below their fair value.
Do you agree? Do you disagree?
Let me know what you think!
And as always, if you have any questions or comments, shoot them on Twitter @TiagoDias_VC or down below!
I’ll see you next time!