Is Valuing A Stock A Waste Of Time?

Should you focus on a company’s quality, rather than its valuation?

saving for retirement

Value investing is a popular method used to decide which shares to buy and sell. The idea behind it is quite simple: avoid paying too much for a stock. While value investing has been used by many successful investors such as Warren Buffett, there are many other drivers behind a share price other than its valuation. For example, a company’s financial strength, profitability and economic moat. Could they be more important than a company’s valuation in determining the level of capital gains?

Limitations

Clearly, every investment strategy has its flaws. Value investing’s obvious flaw is that the best companies rarely trade at low valuations. This can be applied on either an absolute or relative basis. In other words, investors seeking companies which have a P/E ratio below a specific threshold may never end up buying the very best companies. That’s because they are likely to always trade at a premium due to their strong fundamentals. Similarly, those same companies are rarely cheap compared to sector peers, since they offer either superior return potential or lower risk.

Furthermore, it could be argued that valuing a company means an investor will miss out on significant share price gains. Just as valuing a company can be used to determine whether to buy, it also determines when to sell a specific stock. In other words, if a company’s share price appears to be excessive, value investors may decide to sell up and walk away. However, many investors have profited from overvalued shares becoming even more expensive. Therefore, in such scenarios, value investing may be somewhat limited in its ability to generate outstanding profits in the long run.

Catalysts

In addition, it could be argued that few investors will buy a stock simply because it is cheap. There is usually a catalyst required to drive a share price upwards. This could be in the form of growing earnings, an improving balance sheet, growing dividend, a change in strategy or some other event which justifies a higher share price. This means that buying cheap shares may be insufficient to generate index-beating profits, since catalysts may be required in order to push a company’s share price higher.

In such scenarios, it is likely for a company’s share price to rise no matter what its previous valuation, since it represents a change in outlook or risk profile which the market may seek to reward via a higher valuation. Therefore, whether the stock was cheap or expensive before improved profitability or a higher dividend came along may not have a major impact on its share price.

Takeaway

As with every other investment strategy, value investing has its limitations. It can mean investors miss out on major share price gains, while failing to focus on the key catalysts which could equate to capital gains. However, valuing a company may not be a complete waste of time, since it can lower risk and lead to more consistent returns. Therefore, alongside a focus on a company’s potential catalysts, valuing a company seems to be a worthwhile pursuit.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

More on Investing

Dividend Stocks

The 2 Best Canadian Blue-Chip Stocks to Buy Now

Blue-chip stocks can be some of the best stocks to have in any portfolio. But when they're trending upwards, investors…

Read more »

Canadian dollars in a magnifying glass
Dividend Stocks

Here Are My Top 3 Dividend Stocks to Buy Now

These top dividends stocks have consistently paid and increased their dividends. Further, this trend will continue.

Read more »

Lights glow in a cityscape at night.
Investing

Canadian Infrastructure Stocks to Buy Now

These two Canadian infrastructure stocks offer interesting investment opportunities whether you’re focused on income or price appreciation.

Read more »

A plant grows from coins.
Tech Stocks

3 Growth Stocks Wall Street Might Be Sleeping on, But I’m Not

Don’t miss your chance to load up on these three beaten-down stocks.

Read more »

tsx today
Stock Market

TSX Today: What to Watch for in Stocks on Tuesday, November 5

Updates related to the U.S. presidential election will remain on TSX investors’ radar today as the third-quarter corporate earnings season…

Read more »

think thought consider
Tech Stocks

Is CGI Stock a Buy Even With No Dividend Yield?

CGI stock may not have a dividend to speak of. But does that necessarily mean you should ignore this top…

Read more »

A robotic hand interacting with a visual AI touchscreen display.
Tech Stocks

Why Now Is the Time to Invest in Canadian AI Stocks

Are you looking for one of the most solid Canadian AI stocks out there? This one is probably your best…

Read more »

The letters AI glowing on a circuit board processor.
Tech Stocks

Why AI Stocks Should Be in Every Canadian Investor’s Portfolio

AI stocks continue to be one of the best options out there for long-term investing, especially when considering Canadian options.

Read more »