Introduction
One of the most common mistakes that I see common stock investors make is failing to formulate the important distinction between a company and its publicly traded stock.There are many great companies out there with fabulous stories surrounding their wonderful businesses. As a result, it can be very easy to fall so much in love with a great company that you can’t resist investing in the stock even when the valuation is extreme.
Often when a company’s business is doing well, its stock becomes popular with investors. Pundits tend to like popular stocks and often write glowing reports and reviews about the company and how well its business is doing. Ironically, for the most part what is written about the business itself may be true and accurate. Writers will talk about things like how the company is increasing sales and earnings, how it has low debt and strong cash flows, improving margins and returns on equity or invested capital and the list goes on. And since all these accolades and positives about the business (the company) might actually be true, investors can get quite excited about investing in the company’s stock.
On the other hand, even when business is strong, a company’s stock price can get ahead of its fundamentals. When that happens, no matter how strong the business is, the stock enters the realm of becoming a risky and poor long-term investment opportunity. However, it’s important to acknowledge and understand that when a stock has momentum, its price can continue to run over the shorter term. But eventually, the day of reckoning must, and will, come. When it happens, you don’t want to be the greater fool holding the bag.
Additionally, it is an indisputable fact that the stock market often mis-appraises companies at least over short periods of time. History is full of examples such as the tech bubble that ran from the mid-1990s to 2000 where we saw high profile technology companies trading at obscenely high P/E ratios (valuations) of 200 times earnings or more. And of course, it wasn’t long before the bubble burst and the stock prices of those same high profile tech stocks literally collapsed.
Consequently, I can’t believe the notion that the stock market is efficient, nor do I believe that everything that can be known about a stock is always factored into the price. However, I do believe that the market is continuously seeking efficiency. Therefore, when a stock is being improperly valued based on fundamentals, you can be sure that it will eventually and inevitably move back towards its intrinsic value in the longer run. The exact timing is an unknown, but common sense dictates that nosebleed valuations cannot hold forever.
Finally, the primary reason that it’s important to make the distinction between the company and the stock is actually very straightforward. The operating results generated by the business behind the stock, is something that management has some control over. In contrast, the market price that Mr. Market applies to the shares of its stock is not directly controlled by the company’s management. In short, management can run the business poorly or well, but they have virtually no control over the stock market and the price (or value) it places on their shares.
Nike’s Exceptional Operating History
As the following earnings and dividends F.A.S.T. Graphs™ on Nike for fiscal years 2000-2010 vividly reveals, Nike the business performed exceptionally well. Earnings growth was very reliable and consistent, and averaged over 15% per annum. Nike’s dividend over that time frame also followed suit, averaging 15% growth and a similar compound annual growth rate (CAGR) of 14.5%.
Special Bonus: To get a free more detailed perspective on the fundamental merits of Nike (NKE) follow this direct link to a video on my site mistervaluation.com and watch and listen to me analyze Nike out loud via the FAST Graphs fundamentals analyzer software tool.
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The above graph clearly supports the undeniable reality that Nike was a wonderful and superbly run business over this time-frame. Importantly, Mr. Market recognized Nike’s superior business results to the extent that it was willing to generally apply an above average valuation to their shares. As the following graph depicts it was quite common to see Nike trading at a P/E multiple of 19-20 (normal P/E ratio of 19.3, depicted by the blue line on the graph) or higher over this time-frame. I refer to this as a “quality premium valuation,” and Nike has historically been a quintessential example, and arguably deservedly so.
