🧠 The Trickiest Part Of Investing

Friends,

One of the trickiest parts of investing is valuing a business.

Consider the most popular valuation tool: the price-to-earnings (P/E) ratio.

On the surface, it seems pretty simple: the lower the P/E, the “cheaper” a stock is; the higher the P/E, the more “expensive” it is.

But scratch the surface just a little and things get murky.

Consider:

In March of 2013, Netflix shares traded for a P/E of 653. It was “ridiculously expensive.” And yet, over the next decade, the stock was a 10-bagger.
In March of 2008, General Electric shares fetched a P/E of just 4 — a “ridiculously cheap” valuation. And yet, over the next decade, shares lost half their value.

Why did the P/E ratio fail so miserably in both cases?

We think the answer is that it was the wrong tool to judge both companies’ value at the time.

That’s because the P/E ratio is a point-in-time metric. It shows the relationship between a company’s current price and profits. One of its limitation is that it does not factor in how the world around us is changing.

In 2013, Netflix was transitioning from a DVD-by-mail platform to streaming. The early signs were promising, so Netflix doubled-down on the strategy. Yet, the transition had the effect of depressing near-term profits.

In 2008, GE’s trailing profits looked robust, but that was a mirage. GE’s exposure to the financial crises would soon cause its net income to collapse. Plus, several of its business lines were being disrupted.

Of course, it’s easy to point this out with the benefit of hindsight. The real trick is learning to do it in real-time.

And this is just a small sampling of the challenges that investors face when valuing a business.

Investors also need to figure out valuation mindset best matches the investor’s style (value, growth, momentum, GARP, venture). Then, they need to assess which valuation method is optimal for measuring a company’s value at any given time (discount cash flow, earnings multiples, total addressable market, yields). There’s also the challenge of interpreting the results (cheap, fairly valued, expensive, buy, sell, hold).

These factors make valuing a business part art and part science. Mastering the valuation process isn’t easy; but that’s true of every long-term endeavor.

This is why we stress so often that it’s critical to love the process of becoming a better investor. If you don’t, there’s nothing wrong with dollar-cost averaging into index funds and calling it a day.

– Brian Feroldi, Brian Stoffel & Brian Withers

P.S. If valuation is a topics that interests you, check out our free webinar that we held yesterday. Just register here to get the replay link.

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