Valuation Versus Business Fundamentals: Which Should You Focus On?
Should we buy a company just because it is cheap? Is valuation more important than the fundamentals of a company? These are some of the questions that crop up for investors once in a while.
Like most people, when I first started investing, I was deeply focused on valuation. I would religiously scrutinise the 52-week low price column of the newspaper everyday to find companies that were trading at rock-bottom prices. I would look into the business fundamentals only when the valuation of a company satisfied me.
Therefore, in my early years of investing, I found myself investing in many mediocre businesses. Although I had made relatively good returns using this strategy, I have evolved as an investor over the past few years.
Today, I am more focused on finding great businesses to invest in. Valuation is still important to me, but it is no longer the most critical factor when I am deciding on my investment. I found out that basing my investment decisions purely on the valuation of a stock has some serious drawbacks. I present the reasons below:
1. Valuation Is Subjective
Firstly, valuation is a subjective exercise. My estimation of the value of a company can be very different from someone else’s. Therefore, just because I have the valuation of a company in mind, it does not make me right. And very often, I can be wrong.
2. Constant Search For New Companies
Moreover, if we buy a company merely due to its cheap valuation, it may mean that we have to sell it when the price of the stock reaches our target. We then need to start looking for another cheap company to buy. Thus, we have to constantly search for more and more companies to buy and monitor the prices of the stocks very closely. As our portfolio grows, this might become cumbersome.
3. Cheap Rubbish Is Still Rubbish
Lastly, cheap might not necessarily mean good. Many companies are trading cheaply for a reason. If we focus too much on the valuation, we might be investing in bad businesses that will destroy value for us. Always remember, cheap rubbish is still rubbish.
There is no right way to invest. I have made both good and bad investments. However, the key is that we have to know what are the pitfalls of focusing too much on the valuation of a stock. Buying at a low valuation is important, but in many cases, it is not the most important factor in investing.