Not All High-Valuation Stocks Are Priced for Perfection. Here’s Why.

When it comes to things like clothes, food, and cars, people have a good sense of what’s a good price to pay. But knowing how to value stocks is admittedly complicated. There are so many factors that contribute to our understanding of a stock’s fair value, including things like the company’s revenue growth rate, profit margins, and long-term viability.

However, some investors dismiss any stock with a high valuation. Consider this oft-quoted phrase: “It’s priced to perfection.” But this is the wrong way to think about a high valuation in all situations. In the video clip from Motley Fool Backstage Pass, recorded on Oct. 5, Motley Fool contributors Jason Hall, Jose Najarro, and Jon Quast explain why some stocks deserve a premium price tag.

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Jason Hall: Fool Fan says, “For high valuation stocks, as per my understanding, the future growth is already accounted for in the stock price. Does it mean the stock price will go up only if the company performs more than the assumed price and growth? Is my understanding, correct or am I totally off?”

Yes and no. I will say yes and no. First of all, every stock, whatever the valuation is, the valuation is based on expectations for future growth or lack thereof. As an investor, one of the things that you’re looking for, one of the things is an opportunity to buy a company at a fair value based on what you think it can deliver in terms of profits in its future. At its purest form, growth or value investing is trying to buy undervalued assets. A company that will deliver more growth or more earnings over time than the market is valuing it for today.

In general, high-valuation stocks are growth stocks, companies that are expected to grow and they trade for a premium valuation because they are expected to grow their revenues and earnings at an above average rate. Now, does that mean the stock price will only go up if the company performs?

This gets back to the old Ben Graham quote. “In the short-term, the market is a voting machine in the long term, it’s a weighing machine. ” Stock prices can go up for very hard to discern reasons. Look at GameStop and AMC is just two examples. These are two companies that are certainly not in growth mode. The stocks in the short-term have gone up immensely and investors have made a ton of money on those stocks in less than a year.

In the short-term, who knows. If a company continues to deliver over the long term, the stock price should continue to climb. But you just have to remember that the road in between today and that future results is not just up and to the right if the company continues to grow, it can be very volatile.

Jose, thoughts?

Jose Najarro: Yeah, I definitely want to agree with you, it’s not a straight-line growth. Analysts come out and say, “Hey, this is a company that’s expected to grow. Let’s say I’m just throwing a number, 50% compounded annual growth rate.” That doesn’t mean every year is going to hit that 50%. There might be a bad year where something might have happened where the actual growth rate for that year was like 35%.

Sometimes, that scares off investors to some extent so just like Jason mentioned, these growth stocks, I wouldn’t say they’re priced to perfection, but they are priced to me at least some form of minimum and that minimum is usually some percentage of growth that investors should keep an eye out and the exciting thing about growth stocks is, there’s only so much one can expect. There could be a brand-new partnerships that one did not forecast. There could be a whole new market that one didn’t expect this company to into.

Hall: Like an online bookstore turning into one of the largest web services providers on the planet.

Najarro: Exactly, Jason. [laughs] Growth stocks definitely has a lot more volatile than your typical stocks, but the volatility, I want to say is never a risk. It’s more just if you’re able to hand or would stand that volatility.

Hall: Jon, sometimes a company can grow, maybe it doesn’t meet those initial expectations. But can still grow in value, it’s just how much the market is going to recognize that.

Jon Quast: Yeah, Fool Fan, this is — the reason we’re all taking a stab at this is because you’re asking one of the most asked questions and investing — valuation — and there’s so much nuance to the answer.

And so let me put out another example. A high valuation isn’t always the product of a high-growth company, sometimes, it’s the quality of the growth.

Hall: It’s also a picture of the company at this moment in time.

Quast: That is also true. You can have two companies growing at the exact same rate, but one has a 10% profit margin and the other has a 50% profit margin. The one that has the higher profit margin is higher-quality growth and so you could reasonably expect the valuation would be five times that of the former company, even though the growth rates are the same, the quality is improved.

The other thing that I wanted to add on here, it’s what what Jason was saying and what Jose was saying as well and it just went out of my mind. [laughs] Shoot. I’m sorry.

Najarro: Good thing we both said it.

Quast: Good thing you guys both said it.

Hall: I want to hit on the margin thing real quick I think that’s really important. Because that’s really key. That’s one of the reasons that we look at margins so much is because like said, if a companies growing revenues 50% a year, let’s say 20% a year, so 20% a year after four-and-a-half years a company’s revenues are going to roughly double. If the company’s profit margins are 10% over that same four-year period, its operating margins are only going to go up 46%, 47%.

If a company has 50% operating margins, I’m not going to try and calculated in my head, but I think their earnings are going to triple or quadruple over that same period and that’s the key when you look at these higher-margin growth companies, particularly like the SaaS companies and Cloud stocks and that kind of thing. They tend to be the ones that have those kinds of metrics. That’s why a company might sell for 30 times sales, while an industrial company might sell for 12 times earnings because the quality of those revenues.

Jon, go ahead. I think we’ll circle back to what you were trying to remember too.

Quast: Yeah. Thank you for giving me a chance. The other thing that I wanted to point out, and it’s what Jason and Jose were saying, is that there’s timeframes in expectations. What Jason said, expectations are priced into every stock that’s in the market, but over what time period?

Let’s just say generally, the market has expectations for the next year and less and so that’s what they’re looking at. Your advantage as an investor is having a longer timeframe of expectations, so yeah, something may look very pricey now and over the next year. But you’re looking five, seven, ten years down the road and you’re seeing what this company can become. I’m not saying valuations go out the window, but what I am saying is your extended expectations can play to your advantage when it comes to valuation.

Jason Hall has no position in any of the stocks mentioned. Jon Quast has no position in any of the stocks mentioned. Jose Najarro has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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