Now, typically those who are invested in company "B" will say that the growth prospects for "B" are better than "A." That while "A" may be a better value that "B" now, "B" will grow so much faster that not only will it close the gap , but the share price appreciation that will accompany this will make "B" a superior investment down the road - thus it deserves the high valuation. They will cite you many examples from the 90's where stocks like Microsoft, Cisco, Amazon, Dell and Google today and others trounced boring old companies that were bought at fair valuations. You then have to ask what happens when the music stops and the explosive growth becomes...normal?
Let's look at how high valuations can lead to hard times for investors:
Starbucks has been one of the best performing stocks of the past 10 years. Its growth has been extraordinary and its logo and coffee have become American icons. They provide health insurance for all their employees, use recycled paper for their cups and buy "free trade" coffee beans. In short, there is nothing not to like about the company.
The stock, however, is another story. This past summer all was well for shareholders. The stock hit an all-time high of $39 and the future looked very bright. Then, a bump. The company announced its same store sales would fall well short of estimates because it had problems implementing ice new iced drink offerings during the hot summer. Rather than wait outside in line, people sought coffee from other places. Trading at over 50 times earnings at the time, investors panicked and acted first before they asked any questions and took the stock down to $29.55 a share for a 25% loss. The stock has since recovered half the loss and trades at $35 a share. Those who bought before the summer swoon are stuck holding the stock of a great company at a loss to their purchase price. Those who did not own SBUX, but after the summer drop bought it, are sitting on a 17% gain. Two investors, two very different situations.
What happened? In a word: Fear. When you pay that much for the company, at the first sign of bad news you sell just in case the other shoe drops and that news is worse. That is what happened to SBUX. What did SBUX actually say? They had problems serving all those people fast enough. They didn't say that there were no lines, that people only wanted the cheapest coffee they had, that they were losing market share.They only said that they could not make coffee drinks fast enough for all the demand. Now you have doubt in the stock. What if there are other problems? What else is there? Are people tired of Starbucks coffee?
Despite earnings estimates for 2007 from the company that are in line with analyst's expectations, investors are only paying 38 times 2007 earnings now (still too much). That means the stock price is falling as people are not willing to pay over 50 times earnings now that they realized SBUX is not perfect. Another misstep, not matter how trivial, will lead to its multiple to shrinking again and its stock dropping more. Has anything fundamentally changed about the company? No.... the change has been only in the mindset of investors. If you were not smart and overpaid for SBUX, you now own a piece of a wonderful company purchased at an awful price.
In a word: BORING!! They make paint, so what? No Hollywood actors carry their cups around and you really cannot look cool ordering a gallon of red semi-gloss, no matter how hard you try. Their shares have always seemed to trade in a PE range of 10 to 15 times earnings. In early 2006, a Rhode Island jury found that SHW was a "public nuisance" due to lead paint they had stopped producing 50 years earlier. A judge ruled they had to share the cost of cleanup of lead paint in homes and estimates ran up to $4.5.billion in costs. Instant memories of asbestos came to investors' minds and the share were punished 22% over the coming days. Investors feared a landslide of lawsuits from lead paint poisoning. After cooler head prevailed, people realized that there have only been about 2,000 cases of lead paint poisoning EVER. Once the asbestos analogy was diminished, the shares resumed their normal trading at around a PE of 14 times earnings. Shares have not only recovered, but are up 56% from their post-Rhode Island-ruling-low as they have followed the earnings.
Why the difference? Valuation. SHW shares are fairly priced, bad news only effects them to the extent of the news. SBUX shares are overpriced, bad news effects them by eliciting fear and uncertainty, and investors react to uncertainty by selling. Look at the two situations: SBUX is down 10% from its peak due to rather benign news - they just could not make enough coffee fast enough to satisfy the hoards. SHW is up 17% from its high water mark before the ruling, a ruling that has significantly more impact on the bottom line at SHW than SBUX's news did. Had you paid 50 times earnings for SHW shares (as many did for SBUX) before the bad news, you would have been paying about $200 per share and would be in the hole on this stock now, too. Two good companies, two negative events - but for investors, two very different outcomes because of the price they paid for their shares.
Those stocks I mentioned earlier? Since 2000, the approximate top of their valuations: Dell (-44%), Amazon (-42%), Microsoft (-45%) and Cisco (-52%) have all been losers for those who bought in...
Oh Yeah...boring old Sherwin-Williams, whose investors never overpaid for it? UP 240%!
Buy stocks in great companies, just do not pay too much for them.