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Stocks · 09 / 13
Valuation and the investment decisionLevel 2Products8 minUpdated

Why a good company isn't always a good investment

This is the most important insight in stock investing. A company's quality and an investment's expected return are two different things, and between them sits the price.

What you'll learn
  • Why a high-quality company can be a poor investment
  • What it means that expectations are in the price
  • How to assess how much is expected of a company

Two different questions

This is the difference between two questions:

Is this a good company?
A question about the quality of the business.
Profitability, growth, competitive advantage, management, balance sheet. The answer is found in the company's figures and operations.
Is this a good investment?
A question about quality relative to price.
The same company can be a good investment at one price and a poor one at another. The price changes the answer.
YouTube video · in FinnishGood company or good investment? How to think about a stock's valuation

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Good company or good investment? How to think about a stock's valuation
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The price is an expectation of the future

A share price isn't a reward for past success. It is the market's estimate of the company's future earnings, converted to today's value.

When a company is known to be good, it is usually also priced as good. Your return doesn't come from the company succeeding. It comes from the company succeeding better than the price assumes.

High valuation
The market expects a lot. There is little room for error: a disappointment easily leads to a sharp fall.
Low valuation
The market expects little. Even a small positive surprise can move the share price a lot, but a low valuation can also be justified.
Margin of safety
The gap between your estimate and the price. It protects you in case your own estimate turns out to be too optimistic.
Chart · illustrative example
An excellent company, three outcomes
The share is priced on the assumption of 25% annual growth. This is what happens with different outcomes.
Growth 30% · better than expectedStrong return
Expectation exceeded → valuation holds
Growth 25% · expectation metModest return
The price was already here
Growth 18% · still goodNegative return
Valuation unwinds

The middle row matters most: the company performed exactly as expected, and the investment still returned modestly. On the bottom row, the company grew 18%, an excellent performance by any measure, but the investor lost money because more had been priced in.

Turn the question around

A useful way to assess a valuation is to ask: what would the company have to achieve for this price to be justified?

If the answer is “carry on at the current level”, the price is moderate. If the answer requires growth to accelerate, margins to rise and competition to stay away, the price contains a lot of assumptions, and each of them is a risk.

  • Cheap doesn't mean good. A low valuation can reflect a real problem in the business.
  • Expensive doesn't mean bad. An exceptional company can grow into its valuation over time.
  • What matters is the gap between your own estimate and the market price, not the absolute level of the valuation multiple.

This content is for information purposes only and should not be construed as investment advice or a recommendation. Investing always involves the risk of losing capital. The value of financial instruments and investments can go up or down, and past performance is no guarantee of future returns.

Check question
Test yourself: quality and price
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Why can an excellent company be a poor investment?
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What is a useful question when assessing a valuation?
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