Don’t buy stocks at silly prices! Why price still matters, even for great companies

Once you start liking quality businesses, it’s tempting to believe that you can pay almost any price for them. The story feels so strong that valuation becomes an afterthought. We’ve heard this many times: “It’s a great company, I don’t mind paying a bit extra.” The trouble is that “a bit extra” can quietly turn into “far too much”, and even a wonderful company bought at a silly price can be a disappointing investment.Think of valuation as the link between a business and your personal return. The company’s job is to grow its earnings and cash flows over time. Your job is to make sure you don’t pay so much for that growth that even good performance translates into poor returns. Price does not change what the business is, but it does change how much of the future you are prepaying today.Consider a simple thought experiment. Imagine the same company, Hindustan Unilever Limited, trading at two different valuations in two different years. In 2011, it traded at around Rs 340 per share, roughly 29 times its earnings. In 2016, after a lot of excitement and strong past performance, it traded at about Rs 857, which works out to almost 46 times earnings. Over the next ten years, suppose the company does quite well and grows its earnings at 10-12 per cent annually.An investor who bought at the lower valuation in 2010 might earn something like 23 per cent per year over the decade. Another investor who bought the exact same business at the peak valuation in 2016 might end up with a far lower annual return, say 11 per cent, even though the underlying earnings growth was identical. The difference came entirely from what they chose to pay at the start.Indian markets have plenty of real examples like this. Some high-quality names were bid up to extraordinary valuations in 2018 when the narrative around them was at its peak. Investors who bought at those levels had to wait many years just to see their purchase price again, even though the companies themselves continued to grow. If you plug in an actual stock, say Page Industries, and compare the returns from buying it in 2010 at about Rs 850 (PE of roughly 27) versus buying it in 2018 near Rs 36,000 (PE of over 100), you’ll see exactly how dramatically the entry price can distort your experience.At Value Research Stock Advisor, we try hard to separate our opinion of a business from our opinion of its share price. We might admire a company’s economics and management and still decide that, at the current valuation, the odds are not in the investor’s favour. In those situations, we are quite comfortable saying, “This is a great business, but not a great buy right now.” That discipline is uncomfortable when the stock keeps going up and people around you are celebrating. It becomes invaluable later, when reality catches up.Valuation is not about finding some precise magic number. It’s about staying within a sensible band and insisting on a margin of safety. If a business is more cyclical or less predictable, you want a bigger discount to your estimate of fair value. If a business is very stable and capital-efficient, you may be willing to accept a somewhat higher multiple, but there is still a limit beyond which you’re mainly counting on “greater fools” to take it off your hands at an even more optimistic price.You don’t need to build fancy discounted cash flow models to get the basic idea right. Look at simple measures like the price-to-earnings ratio, price-to-book in appropriate sectors, and the relationship between market value and free cash flow. Compare those not only with the broad market, but also with the company’s own history and its peers. Ask yourself what the current price implies: how much growth is already priced in, and how much room is left for positive surprise?If a company has usually traded between 10 and 20 times earnings in the past and is now suddenly at 40, you should at least be curious about why. Sometimes, big changes are justified, perhaps a structural improvement in the business has permanently lifted its quality. Other times, it is simply enthusiasm running ahead of reality. Your job is not to automatically reject anything that looks expensive, but to understand what you are paying for and whether the odds still favour you.It’s equally important not to swing to the other extreme and chase low valuation for its own sake. A company can look statistically cheap at 15 times earnings or at a discount to book value, but if its business is deteriorating, its industry is shrinking, or its governance is suspect, that cheapness can be an illusion. There is a reason value investors talk about avoiding “value traps”, stocks that are cheap for the right reasons and stay cheap while the underlying business decays.This is why, in our process at VRSA, quality and valuation are inseparable. We first ask whether the business passes our tests on growth, returns on capital, balance sheet strength and promoter behaviour. Only then do we ask if the price offers a reasonable margin of safety. Sometimes we like a company very much but are not comfortable with the valuation. In those cases, we wait. Patience can feel like inaction when the stock is on everyone’s lips, but waiting for a more rational price is often the difference between a good story and a good investment.Over long periods, your returns will be driven by two things: how well the underlying business does, and how sensibly you bought it. You can’t control the first, beyond choosing good businesses. You can control the second by refusing to get carried away in either direction, neither overpaying blindly for fashionable names nor mindlessly hoarding the lowest P/E stocks. If you can combine a respect for quality with a respect for price, you’ll find that equity investing becomes much less about luck and far more about quietly stacking the odds in your favour.(Ashish Menon is a Chartered Accountant and a senior equity analyst in Value Research’s Stock Advisor service.)(Disclaimer: Recommendations and views on the stock market, other asset classes or personal finance management tips given by experts are their own. These opinions do not represent the views of The Times of India)