Here is a case study:
There are two stocks: Stock A and Stock B.
In terms of business fundamentals, Stock A generates a constant Return on Equity (ROE) of 6% a year. Stock B generates a constant ROE of 18% a year. Both companies choose to retain their earnings, add to their equity and reinvest them at their respective ROEs. No dividends had been and will be paid to shareholders. Also, they will keep their number of shares constant over time.
In terms of valuation, let’s assume both stocks to have long-term P/E Ratio average of 20. Here, at Year 0, you have a choice to invest:
Stock A at 30% below its fair valuation.
Stock B at 30% above its fair valuation.
In other words, for stock A, its fair valuation is $120 per share. But, you could invest in its shares for $84 a share (30% below $120). As for stock B, its valuation is $360 a share. But, you have to pay $468 a share (30% above $360) for its shares. So, which of the two stocks would you like to invest in?
For some, it is natural to choose Stock A as it is “undervalued”. After all, who doesn’t like a huge discount?
But, here is the thing.
The ultimate prize for investing is to compound wealth at a higher rate of annual returns. With its objective in mind, the question is: “Which of the two stocks would compound investors’ wealth at a higher rate over time: Stock A or Stock B?”
Let’s examine over a period of 40 years.
For Stock A, its EPS could grow from $6.00 in Year 0 to $61.71 in Year 40. Its fair valuation shall grow from $120 a share in Year 0 to $1,234.29 in Year 40 based on a constant P/E Ratio of 20.
Based on investment cost of $84 (a 30% discount from its fair value in Year 0), if you keep Stock A’s shares for 40 years, your annual returns shall gravitate towards “ROE = 6%” over time. Such indicates that the longer you hold onto Stock A, the more it would gravitate to 6% a year.
For Stock B, its EPS could grow from $18.00 in Year 0 to $13,506.81 in Year 40. Hence, with the company’s constant P/E Ratio of 20, its fair value will grow from $360 to as high as $270,136.20 in that period.
As such, despite investing in its shares at a 30% premium of its fair value in Year 0, your annual returns from Stock B shall gravitate towards “ROE = 18%” over time.
At the end of 40 years, the investor who had invested in Stock B shall achieve more wealth than another investor who chose Stock A. In dollar amount, every $10,000 invested in Stock A will be compounded into $146,939 at Year 40. But for Stock B, every $10,000 invested into it shall grow and be worth $5,772.141, which is 39-times better than Stock A.
Thus, in investing, it is better to pay a premium for quality over a discount for “inferiority”.
Fundamentals triumphed over valuation over time.
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