How Important Is Valuation When Buying Stocks?

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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