When It Pays to Prove Yourself Wrong

When It Pays to Prove Yourself Wrong

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That's a word that makes sense to me. It makes a lot more sense to me than bitcoin, the monetization of Twitter , or the future of robots that perform surgery.

When the stock market prices a stock so that the total market value for the company exceeds what that company is truly worth, that company is... you guessed it: overvalued.

The trick when it comes to investing is -- and bear with me because this is going to get really complicated -- not buying overvalued companies and instead buying undervalued ones. Still with me?

To me, this always clicked as the right approach. Intuitively, it makes perfect sense, and, to brag just a bit, my Motley Fool CAPS track record suggests that this approach has worked out pretty well for me.

But there's a big problem with this approach. While it's perfectly easy to see the price that the market puts on a company, it's extremely tricky to figure out what the company is worth. There are lots of ways to try to figure out what a company is worth -- methods that span from a simple price-to-earnings ratio to uber-complex Excel-crashing valuation models. Over the years, these approaches have given a lot of number crunchers like me much glee... and probably even more false confidence.

The shortfall of most of these valuation exercises is that they typically rely on a combination of current financial results and projected future growth and changes in the business. That may sound reasonable enough until you step back to consider:

  • In the year 2003, when Neflix was barely profitable and it was relying on physical DVDs in red envelopes, how do you model in the future of streaming movies?

  • In 1999, when Amazon.com still described itself as "the Internet's number one book, music and video retailer," how do you account for the day when it'd be selling everything from cloud computing services to its own branded tablet and Hello Kitty water bottles?

  • At the end of 2001, Apple released the first line of iPods. But that year's net loss hardly suggested that the company would end up a dominant force in the smartphone market.

If you're clairvoyant, you may be able to build these kinds of wild scenarios into that super-complex valuation model. But I can promise you this: None of this will ever show up in a P/E ratio.

Thanks to that latter point, some of the best companies of our time -- Netflix, Amazon.com, and Google -- just to name a few, have been eschewed by many investors and batted around by the media thanks to that word. Yeah, you know what I'm talking about: overvalued.

For the love of numbers
I assume that readers most skeptical of this are readers just like me -- that is, investors who love numbers. So all of the squishy stuff I've presented so far may not seem particularly convincing.

So I've got numbers.

Specifically, I looked back at the big winners and losers over the past decade, focusing on companies that were valued at $100 million or more 10 years ago. My first test was to simply look at the correlation between valuations -- based on P/E ratios -- and stock performance. If lower valuations were indeed necessary for better stock performance, then we'd expect to see a strong negative correlation.

I didn't get that. Not even close. Based on my data set, the correlation between P/E and stock performance over the past decade was 0.018, or, translated from stat-speak: There was basically no tie whatsoever between stock performance and the P/E at the beginning of the period.

But there's more. When I looked at the stocks that returned 25% or more per year over that 10-year period, they had an average P/E of 27 -- above the overall average of 25. The median P/E was lower (17.4), but still above the overall median (16.9). In other words, the top-performing stocks had higher-than-average valuations at the start of the period.

Maybe even more interesting was at the other end of the spectrum. Of the stocks that lost 75% or more of their value over this stretch, the median P/E was 15.9. Yes, you read that right. The worst-performing stocks were valued at lower multiples than both the best-performing stocks and the group as a whole.

Why this isn't as crazy as it sounds
Motley Fool co-founder David Gardner wouldn't be surprised one iota by hearing this. In fact, in David's list of "six signs of a potential Rule Breaker," the No. 6 sign is "You must find documented proof that it is overvalued according to the financial media."

Earlier this week, I had a chance to chat with David and he reiterated that exact point, but explained to me that the problem is that the current value of a company hinges on so many more things than current earnings. Good management adds to the value. A revolutionary product and a huge market opportunity add to the value. A platform that allows the company to profit in many different ways (think Amazon moving from selling books to selling basically everything) adds to the value. And so on. These are real, valuable assets for a company, yet they don't show up in the current bottom-line tally.

In the end, the task of investing is still really about the premise I started with above: Buying the stock of companies that are worth more than the price tag that the market has put on them. But the trick is knowing how to tally up that true worth.

And, dare I say it, sometimes that means knowing that the word "overvalued" may be more of an opportunity than a risk.

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The article When It Pays to Prove Yourself Wrong originally appeared on Fool.com.

Matt Koppenheffer owns shares of Apple. The Motley Fool recommends and owns shares of Amazon.com, Apple, Google, and Netflix. 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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Originally published