Does Valuation Matter? Less Than You Think If You Buy Quality

Summary:

• S&P has an estimated P/E of 23 for 2020.
• Rich valuations sometimes make the best companies’ share price languish.
• Low interest rates justify high valuations.
• Indexers might suffer more from high valuations than active investors.
• How important are growth and valuations? I look at theoretical returns under different valuations and growth.
• It turns out Warren Buffett is right: It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Even the best stocks suffer from extreme overvaluation:

As of today, the US stock valuations are at the highest since 1999, a time when the dot-com valuations went completely out of whack. In the decade after 1999, we witnessed the share price of fantastic companies like Coca-Cola, Intel, Cisco, and Wal-Mart languish despite delivering growth and excellent operational performance. The chart below shows Intel’s share price from 1990 to 2017:

Intel surpassed the peak in 1999 in 2019! This is remarkable, given the fact that Intel has grown both revenue and earnings over this period. The reason is valuation: in 1999 Intel was valued at over 70 times earnings, while today the market only values the earnings at 13.

Valuations are currently high:

Today, earnings are expected to be 126 dollars per S&P 500 (for 2020), indicating a P/E of about 23. That is pretty high, but still below 44 at the peak in 1999.

However, this might be perfectly justified due to the low interest rates (or even negative interest in some markets). What are the options for investors? Investing in long-term treasuries for 1% or in the stock market for an earnings yield of 4.35% (100 divided by 23) where the latter has a potential for future earnings growth? For me personally, this is an easy choice: I choose stocks. I have never been a bond investor.

Valuations are negatively correlated to share price:

Academic research shows the correlation between valuation and share performance is negative: High valuation leads to lower future returns and vice versa:

But this is the overall stock market and measures average values, and you should always be very careful about making generalizations. Some stocks trade at 50 times earnings, while others trade at 10. For example, Philip Morris (11 reasons to own Philip Morris), the best performer of the last century, currently trades at a 2020 estimated PE of 14. Altria, another tobacco, trades at 10! We heard the same negative stories about tobacco stocks during the dotcom bubble, even Warren Buffett was supposedly past his prime at that time, but tobacco stocks have crushed the market since then. Thus, index investors should be more careful about the current valuations than active investors because the latter can find and research good companies valued fairly.

Two practical examples of valuation and share price performance:

Now, let’s look at some math to show how growth and valuation pan out over a period of twenty years:

Assume you have Company A trading at 100 with an earnings multiple of 24. Earnings compound at 10% like clockwork, but despite this, the market values the company at only 17 after 20 years. This leads to the following sequence of stock prices (shareholder distributions are left out for simplicity):

(You can find the spreadsheet by clicking here.)

		Growth:
		1.1
Year	EPS	PE	Share price
0	4.166	24	100.0
1	4.58	24	110.0
2	5.04	24	121.0
3	5.54	23	127.5
4	6.10	23	140.3
5	6.71	23	154.3
6	7.38	22	162.4
7	8.12	22	178.6
8	8.93	22	196.5
9	9.82	21	206.3
10	10.81	21	226.9
11	11.89	21	249.6
12	13.07	20	261.5
13	14.38	20	287.6
14	15.82	20	316.4
15	17.40	19	330.6
16	19.14	19	363.7
17	21.06	18	379.0
18	23.16	18	416.9
19	25.48	17	433.1
20	28.03	17	476.5

Despite a huge contraction in the valuation from 24 to 17, the stock delivers a CAGR of 8.12% over this period. This shows that over the long-term a moderate overvaluation has only “insignificant” importance as long as you get the growth correct (which of course is not easy).

Now let’s compare this to 5% growth in Company B that has an expansion in the valuation from 10 to 17 over a 20 year period:

		Growth:
		1.05
Year	EPS	PE	Share price
0	10	10	100.0
1	10.50	10	105.0
2	11.03	10	110.3
3	11.58	11	127.3
4	12.16	11	133.7
5	12.76	11	140.4
6	13.40	12	160.8
7	14.07	12	168.9
8	14.77	12	177.3
9	15.51	13	201.7
10	16.29	13	211.8
11	17.10	13	222.3
12	17.96	14	251.4
13	18.86	14	264.0
14	19.80	14	277.2
15	20.79	15	311.8
16	21.83	15	327.4
17	22.92	16	366.7
18	24.07	16	385.1
19	25.27	17	429.6
20	26.53	17	451.1

The CAGR is 7.85%, still lower than Company A despite a huge expansion in the valuation. Bear in mind that a 5% earnings growth is much better than the average company, and beats inflation handily.

In both cases, we assume that the earnings compounds, ie. the retained earnings grow at the same rate as before. That is of course extremely difficult in the real world, and very few companies have opportunities to reinvest the earnings at the same marginal rate of return.

Let’s finish by looking at a more extreme scenario where Company A’s valuation drops from 50 to 17, but still growing 10%:

		Growth:
		1.1
Year	EPS	PE	Share price
0	4.166	50	208.3
1	4.58	47	215.4
2	5.04	45	226.8
3	5.54	40	221.8
4	6.10	35	213.5
5	6.71	33	221.4
6	7.38	32	236.2
7	8.12	31	251.7
8	8.93	22	196.5
9	9.82	29	284.9
10	10.81	27	291.7
11	11.89	25	297.2
12	13.07	24	313.8
13	14.38	23	330.8
14	15.82	22	348.0
15	17.40	21	365.5
16	19.14	20	382.9
17	21.06	19	400.1
18	23.16	18	416.9
19	25.48	17	433.1
20	28.03	17	476.5

The return is still compounding at 4.2%, beating inflation.

What happens to a 5% growth company that is overvalued?

		Growth:
		1.05
Year	EPS	PE	Share price
0	10.00	25	250
1	10.50	25	263
2	11.03	25	276
3	11.58	24	278
4	12.16	24	292
5	12.76	23	294
6	13.40	23	308
7	14.07	22	310
8	14.77	22	325
9	15.51	21	326
10	16.29	21	342
11	17.10	20	342
12	17.96	20	359
13	18.86	19	358
14	19.80	19	376
15	20.79	18	374
16	21.83	18	393
17	22.92	17	390
18	24.07	17	409
19	25.27	16	404
20	26.53	15	398

CAGR is a more modest 2.35% (more or less in line with the median return for any company over the last century), even below the inflation rate over the last 20 years. Thus, if you overpay and it turns out that your expected 10% growth doesn’t materialize, you face two headwinds: low earnings growth and most likely a contraction in the valuation. This is why Warren Buffett only invests in companies where he is confident he knows future earnings growth.

Conclusion:

What is the lesson from this exercise? Quality matters more than valuation (over the long-term).

A lot of investors spend a lot of time trying to time both the market and when to buy mediocre/average companies, often leveraged, fragile and cyclical companies. I have done this mistake myself multiple times over the last decades, just to find out that my best stocks are those where I have spent the least amount of energy on and just held on to. It’s far better to spend time on researching just a few quality companies and avoid the mediocre ones. I believe that this website has provided some interesting quality companies to research on your own.

Warren Buffet and Charlie Munger are correct in saying that it’s far better to buy a wonderful company at a fair price than buying a fair company at a wonderful price.