Valuation Still Matters... Especially Now

Valuation Still Matters... Especially Now

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Over the past year, we've witnessed quite a run in the stock market. The S&P 500 is up 21%, the Dow is up nearly 18%, and some individual stocks have just gone bananas -- witness Zillow's 133% run, for example.

Far be it from me to throw water on the party. And, in fairness, while I think some stocks have gotten too hot to handle, I don't think we've reached a point where the entire market is out of control.

At the same time, I think now is as good a time as any for a reminder that valuation does matter. For some help with that reminder, I went digging in The Motley Fool archives. As luck would have it, Whitney Tilson -- yes, the present-day money manager who modeled his fund after the investing principles of Warren Buffett -- wrote an article back in 2000 titled "Valuation Matters."

Here's what Tilson had to say:

For a number of years now, we have been in a remarkable bull market where valuation hasn't mattered. In fact, I believe that the more investors have focused on valuation in recent times, the worse their returns have been. But this hasn't been true over longer periods historically, and I certainly don't think it's sustainable. While the laws of economic gravity may have been temporarily suspended, I do not believe that they have been fundamentally altered.

Don't get me wrong -- I'm a big believer in the ways that the Internet (and other technologies), improved access to capital, better management techniques, etc., have positively and permanently affected the economy. Nor am I the type of value investor who thinks that anything trading above 20x trailing earnings is overvalued. I simply believe in the universal, fundamental truth that the value of a company (and therefore a fractional ownership stake in that company, which is, of course, a share of its stock) is worth no more and no less than the future cash that can be taken out of the business, discounted back to the present.

We're in a very different environment today than the one that Tilson was writing about. With the financial crisis firmly fixed in many investors' brains, a big question for many has simply been, "Should I own stocks at all?" Now, looking at the booming market of the past year, it seems reasonable to conclude that the fear is abating. And, unfortunately, the way it tends to work in the stock market is that the fear slowly morphs into greed, and the question of whether stocks should be owned at all changes to the hyperventilating conclusion that not only must stocks be owned, but they must be owned no matter the price.

Thus, the importance of Tilson's message.

When done right, the how's of the valuation question aren't -- as Tilson noted -- simple, single-number pass/fail calculations. With that in mind, here's how he said he thought about valuation in practice:

The beauty of valuation -- and investing in general -- is that, to use Buffett's famous analogy, there are no called strikes. You can sit and wait until you're as certain as you can be that you've not only discovered a high-quality business, but also that it is significantly undervalued. Such opportunities are rare these days, so a great deal of patience is required. To discipline myself, I use what I call the "Pinch-Me-I-Must-Be-Dreaming Test." This means that before I'll invest, I have to be saying to myself, "I can't believe my incredible good fortune that the market has so misunderstood this company and mispriced its stock that I can buy it at today's low price."

Do these kinds of valuations exist today? I believe they do. AIG has made an impressive amount of progress in repairing its business, and at a book-value multiple of 0.74, I don't think the market is giving the company nearly the credit it deserves. Likewise with JPMorgan . Its performance has set it apart as one of the premiere big banks in the world, but regulatory and backward-looking London Whale concerns have kept the valuation at an attractive level.

But investors have to be discriminating and keep valuation in mind. On the other side of the spectrum, a stock like BofI Holding has absolutely taken off, and now carries a valuation that will provide a stiff headwind to shareholders' returns in the years ahead. That doesn't make it a bad company -- I believe very much in the impact that technology can have in the banking industry. It just makes BofI a stock better suited for your "watch list" than your "buy now" list for the time being.

Focusing on high-quality, well-run businesses, and investing for the long term are cornerstones of Foolish investing. But, as the market chugs along at a breakneck pace, it's important to remember that the price you pay is important, as well.

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Matt Koppenheffer owns shares of JPMorgan Chase & Co. and American International Group. The Motley Fool recommends American International Group, BofI Holding, and Zillow. The Motley Fool owns shares of American International Group, BofI Holding, JPMorgan Chase & Co., and Zillow and has the following options: long January 2014 $25 calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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