“[Insert Stock Name]” Is Too High!
IMPORTANT: Please read the disclaimer before continuing.
How often do you hear about this?
Facebook’s share price is too high!
Amazon’s share price is too high!
Visa’s share price is too high!
As investors, it is almost a sin to judge a company so quickly.
A few days ago on my Facebook, I asked this question below:
Today, I want to debunk the belief system about a high share price is expensive.
Before we move on, read this article “Share Price Alone is Meaningless“.
Using the concepts in the articles, I will illustrate using the example of Alphabet.
At $521.51, it’s expensive for some.
At $955,14, it’s expensive for some because the share price has gone up.
At $1,334.25, it is even more expensive because it has gone above $955.14!
Why is this a wrong thinking?
We are assuming that the profits of Alphabet (Google) remains stagnant.
What do I mean by that?
Ice Cream Example
Imagine, in the year 2015, you bought into an ice-cream business for $10M. That year, it made $1M, so you are paying a price multiple of 10x.
Then, in the year 2019, your friend Daniel bought your ice-cream business away for $30M.
What’s the price difference? $30M minus $10M = $20M.
Is Daniel making a serious mistake here? He paid $20M more for the same business which you purchased in 2015!
On the surface, this is what we are assuming when we shout that share price (the price tag) is higher hence it is “expensive”.
What if the same ice-cream store makes $5M in now instead of $1M in 2015?
Taking the purchase price of $30M divided by $5M profits, Daniel is paying a price multiple of 6x for the business.
| 2015 | 2019 | |
| Purchased Price | $10M | $30M |
| Profits | $1M | $5M |
| Price-Multiple | 10X | 6X |
Daniel paid 6x for the same business in 2019 as compared Daniel’s paid price multiple of 10x in 2015?. Who is financially shrewd one?
This is why quick judgements tend to hurt new investors who do not consider the earnings of the businesses.
This is why investors tend to miss out on great companies because we assumed that their share prices are too high, hence too “expensive”.
It also applies to buying properties too. You cannot assume a property is expensive without considering the future value and the potential developments around it.
Let’s bring it back to Alphabet example.
Alphabet Example
credits: CBinsights
For FY2015, Alphabet was earning $28.0 billion in adjusted profit.
For FY2019, Alphabet has reported 9M of their 2019 results, using some of their historical growth rates, I estimated they were be earning close to $41.6 billion.
| (in billions) | FY2015 | FY2019 | Change |
| Adjusted Earnings | 28 | 41.6 | 48.6% |
The earnings of the business are growing, hence, it is normal for the share price to move up too.
A higher share price does not mean it is expensive — as long as it is justified by growing earnings.
Shareholders who understood this fact would have made 158% during this timeframe!
Now…
How do you know whether the share price has moved too much ahead of their earnings?
You have to check the valuations of the company or in other words, the price multiple!
credits: Morningstar
Key Takeaway
- When you are buying a company, never ask what is the share price. Ask what is the valuation.
- If the valuations are too high, do not buy the business. Be patient.
- If the earnings are growing, it does not mean you can buy the business immediately. Find out about the valuations.
3 Responses
On hindsight, what you said are all correct. Main problem for most people is that we are all living in the present, evaluating if that company can continue growing. Are we overpaying, etc. Do we really know if facebook, alphabet, amazon, booking…etc are at high valuations now or their future growth is going to be phenomenal that in fact the price is considered on the cheap now. Thats the crux of the matter.
Exactly! As investors, let’s put in a bit effort and read earnings transcripts and use some data points, you are able to foretell some growth. 😃
Investing is a probability game, as an investor we can do our best to read up and dig up whatever info we can find about the business, its management, its industry, its valuation, etc. to increases how well we know about the company and let Mr Market to do it magic.
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