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With stock valuations quite literally all over the map in recent months amid record market volatility, how should investors utilize this metric when deciding whether or not to buy a stock? In this segment of Backstage Pass, recorded on Jan. 26, Fool contributors Rachel Warren and Jason Hall respond to a member’s question.
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Rachel Warren: One from Adam O, he said, “I appreciate the conversation. Fearful to think if stocks go up then they will be considered overvalued.”
I know that we talked about valuations a lot on the show. Some stocks, I guess you could argue are still overvalued. You have to look at the business as a whole. Do you have thoughts on this, Jason?
Jason Hall: Yeah, I do. I think what you have to remember is that a lot of these high-growth stocks are still growing their revenues at very, very high rates.
If you have a company and they are still growing their revenue at 30% per year, and we’ve seen the stock price fall 30% a year from now, if the valuation stays exactly the same, the stocks should go up 30%.
Even if we see the valuation come down 10%, the stock will go up 20%. There’s a relationship between the price to X and whatever X is.
If the company is growing X at a faster rate than whatever the market may be lowering the valuation at, it can still generate returns. That’s the thing.
Warren: Well, and it’s like price shouldn’t keep you from buying a really great company.
Sometimes, we see especially companies in certain sectors, those valuations are just traditionally high. A low price isn’t necessarily an indicator to buy a stock, but a higher valuation, just the same, should not keep you from investing in great companies with a lot of growth potential.
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