Among the many challenges to filtering out good long-term stock investments is determining a reasonable price to pay for shares. Various methods are used to arrive at this value, many of which incorporate a measure of how high today’s price is relative to some fundamental metric. These are typically referred to as price multiples; one of the most widely used is the price to earnings ratio, or PE.
While it can be tempting to categorize businesses selling for a PE well above the S&P 500’s historical range as too expensive, this can lead to missed opportunities. The same can be true on the flip side where a low multiple is taken to represent a good value.
There are a number of reasons why shares of some entities consistently trade at above average valuations. In addition to a sustainable competitive advantage, this can include a strong balance sheet, a high percentage of earnings that is converted to free cash flow and a business model built on recurring revenue relationships. These companies often enjoy pricing power, are well positioned to weather any type of business environment, have earnings that are viewed as higher quality due to their heavy cash component and whose future profits are much more predictable. On the other hand, there can be structural reasons why a stock is selling at a below average multiple versus prior levels despite containing some of these attractive characteristics.
This all circles back to research and doing your homework to determine if current price multiples are based on short-term factors or are a typical characteristic of a company. Categorizing shares as too expensive or a good value based only on current levels is often inappropriate. Further digging can unlock situations offering attractive upside or help avoid those appearing to offer good value but actually contain a higher level of risk than may have been in case in the past. Be sure to consult your advisor to discuss the best investments for your long-term financial goals.
Investment advisory services offered through CWM, LLC, a Registered Investment Advisor.