101:Quality Vs Valuation (Ep.2)

Know exactly what you’re buying!

The stock market has been your best friend since March of 2020. But don’t take that relationship for granted.

In this video/article, we will be looking at two very important metrics you must consider when taking on any investment, those being the quality of the company, and what price you’re actually paying to acquire shares (valuation) of that company.

Just remember although you’re making money in the stock market, everyone is a genius in a bull market.

Fair Value vs Actual Stock Price

When picking stocks, its important that we take into consideration the fair value of our investments.

The fair value can be described as the price that would be received if we sold an asset (in this case stocks) at any given time in aperfect world’.

However, as we know it, the world is far from perfect, meaning that we could pay more or less to acquire a stock compared to what they’re actually worth. 
As investors, we are always trying to acquire shares in a Company at a level which is below fair value, to enable us to beat the market.

In the above graph, the blue line represents the fair price of a stock , whereas the orange line represents the actual price of the shares over a 21 year period.

As you can see for yourself, sometimes shares may trade a premium (i.e. when the orange line is higher than the blue line) or at a discount (i.e. when the blue line is higher than the orange line).

When purchasing a stock it is important to take into consideration these metrics, as it may save you the risk of getting in too high or missing out on the lows. The longer you track your stocks, the better an idea you’ll have on what is considered to be a good entry/exit point.

Unfortunately for us, the actual fair price of a stock is unknown. In a perfect world, the orange line and blue line should coincide with each other, but since the market is irrational, fluctuations occur, hence the two different lines.

As stated before, in our article Risk & Reward we highlighted that sometimes the market may provide us with opportunities to purchase shares at a discounted price, as it did in March 2020. 
It is recommended that all investors hold a shopping list of good companies that they’d wish to own, so that when the market does give us this opportunity, we’ll waste no time buying!

Quality vs Valuation

After considering the share prices of your investments and/or potential investments, you should also assess whether or not your investments are placed within good quality companies, and understand whether or not the share price justifies the quality of the company. Here’s why…

If a Company qualifies as a ‘quality’ investment then analysts will assume that the company is in a good position to grow and reach its strategic objectives in the long-run. When this is the case, share prices tend to be trading at a premium.

The below graph should be your road map to assessing the quality of a company and matching that against its share prices, to beat the market.

On average, stocks tend to lie on the blue line presented below, however, as a general rule of thumb you’re always trying to find companies that lie above the blue line’.

Take Co.1 of this graph. Although the share prices are considered to be expensive, the ‘quality’ of Company justifies the share valuation, and growth potential. We took Amazon as an example of this in the video.

In the Case of Co2, we used financial institutions as an example.
Due to Covid-19 the stock value of several reputable financial institutions have been brought down in share price. 
Some of these institutions would qualify as a ‘quality’ Company. However, because of the implications of the pandemic ‘quality’ companies operating in this spaces may be trading at a discount. Hence the cheaper valuation, and their placement above the blue line.

Co4 represents what is called a Value trap. Those are the Company’s that sit on low share prices, and may be appealing to investors. However, one must note that those companies are cheap for a reason. 
That being, their poor quality.

These types of stocks can either not move much, or continually decrease in value over time. An example of this would be Deutsche Bank.

Co3 represents the no go zone. To get our point across, we took the ‘Dotcom bubble’ as an example.
In the early 00’s any company that was mildly associated with the internet was hyped up resulting in astronomical share price valuations. Even then companies with the lowest ‘quality’ were generating unrealistic excessive returns. Investing in these sorts of companies is extremely risky and can often result in significant losses. Or more recently AMC and Game stop.

Anyways, Let’s look at Oracle to further explain:

Prior to the Dotcom bubble we could argue that Oracle was fairly valued given the quality of the company at the time. 
However, in late 2000, the share price of Oracle shot-up to around $45 due to the hype around internet companies at the time. Although Oracle could be seen as a quality software company, the share-price was not justifiable. In fact, once the bubble popped, it took Oracle roughly 15 years to reach its previous highs. 
This as could be simply explained in the below graph:

Prior to the inflation of the stock prices, we could argue that the share prices of oracle were fairly valued, and hence were placed on the blue line. However, due to the inflation in the valuation of the company, the share prices shifted below the line, whereas, the ‘quality’ of the company had remained the same. This in turn resulted in the share prices to be ‘over valued’.

An indicator that may help investors establish whether or not share-prices are under/over valued, is the P/E ratio. Which we talk about in the video, so be sure to watch.

In summary, to beat the market, you are not necessarily looking for a fantastic quality company, you’re looking for a company whose valuation level is too cheap when you compare it to typical companies with the same level of quality.

At this point you’re probably asking what exactly makes a Quality Company?

When assessing whether or not a Company qualifies as ‘quality company’. You need to be looking out for these main areas.

  1. The Industry sector;
  2. The Company Management;
  3. The Financial Statements and Financial Ratios;
  4. Supplier and Customer lists; and
  5. Whether the Company has a competitive advantage that may create a ‘competitive Moat’.

We’ll be covering these areas in future videos.

To Wrap it all up

Before jumping on any investment, its important that people starting out their investment journey have a good understanding of the quality of the companies they are investing in, and whether the share prices rightfully justify such valuations.

Determining the valuation of a company is a technical area that investors on all levels need to be aware of. In this article we used the PE ratio as an example, however, this should not be seen as the only metric.

We’ll be discussing valuations in a later chapter of this series.

As a final note, even though there is a lot of hype around stock investing at the moment, one should always approach with caution. 
Historically, the valuations of the stock markets have never been this high so ensure that you understand the key qualities of your investments. If a steep pull backs occur, you’ll sleep a lot better at night.

If you’re interested in joining us on our journey, join our Facebook group: The Investment Hub — Malta

Any views or opinions presented in this article are personal and shouldn’t be taken/used as professional advice as we are not qualified financial advisors.
Any statistics mentioned have all been linked to their respective documents together with their ownership.
Lastly, we would like to note that this article has no tie to our professional jobs and was conducted in our free time.