Introduction
Although getting valuation right before you buy a stock is critically important to the long-term oriented retired dividend growth investor, it is not a short-term market timing concept. My point is that short-term market movements are typically volatile and unpredictable. The reason is simple. Over short periods of time, which I define as less than a business cycle (3- 5 years), emotion has a major effect on stock prices.
When dealing with common stock investments, the primary emotions that interfere with reason are fear and greed. However, there are also subtle nuances associated with these primary emotional responses. For example, if a stock is running to the upside, investors might feel they are missing out and invest regardless of valuation. Although this is related to greed, it is a milder form. Conversely, if a stock is falling precipitously, panic often sets in motivating investors to sell regardless of fundamental strengths. Panic is related to fear, but it is an extreme form.
This speaks to the reality that between the two primary emotional responses (fear and greed) that investors face, fear is both the most influential and the most dangerous. In my experience, more money has been lost through panic selling than through overpaying. This is especially true when investing in high-quality dividend growth stocks with consistent records of above-average earnings growth. Again, the reason is simple.
When the emotional response kicks in, logic and reason is often disregarded and people can mistakenly buy when they should be selling and/or sell when they should be buying. Sometimes this works out okay in the short run, but in the long run it usually ends up creating poor, and in some cases, disastrous results. If you overpay for a growing business, you face the prospect of earning less than the company’s earnings growth would produce if you were more prudent. However, if the business is truly growing, you might still make money even though it is most likely less than you should have made.
In contrast, if you sell a valuable business for less than it is worth based on fundamental strengths, you turn an unrealized and usually temporary loss into a true, permanent and realized loss. This is just one reason why fear is a more dangerous emotional response than greed.
Valuation – What It Is and How It Works
Fair valuation is a metric that astute fundamental investors focus on to ensure that they are making a prudent investment decision when considering a stock to purchase. However, it is not a metric that is driven by short-term stock price movements. In other words, valuation is not concerned with price momentum in either direction up or down. At its core, valuation relates to a company’s past, present and potential future earnings power in relation to the price you are being asked to pay to buy it.
In this context, fair valuation relates to the earnings yield that an investment in a stock offers based on its current price in relation to the company’s earnings and/or cash flows. A common valuation measurement that many investors rely on is the P/E ratio. However, the P/E ratio metric simply serves as a quick guide for determining earnings yield. Earnings yield can be calculated simply by inverting the P/E ratio to an E/P ratio (earnings divided by price).
