Investors should not compare the price of their stock with different stocks or with the whole market, but with the real value it should have, in order to avoid the problems that arise if a whole sector (or the market as a whole) is overvalued.
In normal circumstances, we could never justify a P/E ratio of 25 for a company that will never grow its bottom line, even if it is the most famous company in the world and regardless of the sector in which it operates. In the end, what investors should care to value companies is how much cash can be taken out of a business during its remaining existence.
If we find companies with low ratios and very good expectations of growth, we limit the risk of a potential price decrease even if earnings of the company in the future are not as good as expected.
We could make returns with a company that does not increase earnings if you buy it at a P/E ratio of 8 and sell it at a P/E ratio of 10, just because the market sentiment has improved. Obviously, it will be easier to get good returns from companies growing earnings at a good rate per year.
“If you buy a company at a fair price, and in 10 years it is generating 3 times more, it is highly likely that the company will be worth at least 3 times more. Also, if you buy a company which doesn’t grow and in 10 years it has the same profits, it is highly likely that the company will have at least the same value, but if you have bought it at a low price and it has distributed its profits among shareholders, the return will have been good”. – Buy & Hold letter to shareholders, 2016.
Sometimes the market allows you to buy high growth companies for low multiples. For instance, Mark Leonard, the CEO and founder of Constellation Software stated that they have a number of business where their current profitability exceeds their original purchase price.
That’s also the case with some of Buffett investments.
Once we know what drives the stock market and how it is possible to achieve high returns, the priority should be to find undervalued companies with strong competitive advantages. To achieve this, we need to get as much valuable information as possible to estimate the future prospects of the firm.
*If you want more details about investment valuation methods such as discounted cash flows or multiples, we recommend the book “Investment Valuation, Tools and Techniques for Determining the Value of Any Asset” or “The Little Book of valuation”, both written by Aswath Damodaran.