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Don’t Let Simple Valuation Ratios Muddy the Big Picture

One pitfall that I think is very easy for us investors to fall into is getting blinders on and looking at some simple valuation ratios and making that the most important part of any investment.  Honestly, I know that this is something that I struggle with a lot.

I am a very analytical person and I love processes and procedures, so when I first started investing, the first thing that I tried to do is I would try to find the perfect process to run a stock screen to get a great stock.

I was more focused on finding a company that appeared to be undervalued by looking at the valuation ratios than I was focused at actually looking at the future outlook of the company.

Sure, a low P/E is great, but maybe the company has a really low P/E just because it’s a really bad company?

It can be extremely easy to look at some of the valuation ratios and confuse a bad company as one that is undervalued, so you need to make sure that you’re taking it a step further and looking at some of the qualitative data as well.

In episode 158 of the Investing for Beginners Podcast, Andrew and Dave both walked through two examples that I thought were really good.

Dave talked about how a student analyzed Tesla and put together a recommendation for where the student thought that the company could grow to in the future.  The issue is that the student simply just looked at some historical growth rates for Tesla and applied them blindly to the company. 

By doing this, the projection for Tesla’s revenue would eventually outpace the entire GDP of the U.S., meaning 100% of things made in the U.S. would come directly from Tesla.

Tesla?  No way.  Amazon?  Maybe. 

😉

I think this was a really good example that sometimes we can get too close to something that we forget to take a step back and actually look at the numbers that we’re assuming/projecting. 

It’s more likely for small companies to grow much faster than large companies, so that revenue growth projection likely needed to be tamed down quite a bit, especially when comparing it to the entire GDP of the U.S.

The example that Andrew then gave was something that I loved.  He has been looking at investing in a company that sells winter equipment to end consumers.  All of the simple valuation ratios like P/E, P/B and P/S looked great, but he wanted to take a step beyond that. 

He started looking more into the company and it turns out that a very large majority of their sales occur in the snowbelt in the NE and also a little bit in Canada as you might expect.  Andrew then took it one step further and looked at the population trends in the U.S. and sure enough, nobody is moving to the snowbelt nowadays.

It turns out that people are leaving this area of the country so unless this company was going to simply become an even bigger, more dominant player in the game and sell to a higher percentage of people, then this was going to be a slow bleed as their potential consumers move to warmer climates.

To add to Andrew’s comments, a thought that I had during the podcast is that if you’re one that believes in global warming and that the earth’s climate is really changing, is that going to potentially shrink the winter “window” where people might have the ability to partake in winter activities?

Even if it’s a small shrinkage, that is less time that there is to do activities meaning less wear and tear on clothing, toys, etc., meaning less of a need to have to get new stuff and decreasing the regularity that your customer base would purchase new items.

It’s not necessarily some incredibly complex thought process, and honestly, it’s the exact opposite, but it’s extremely important to try to take a step back and think about the big picture rather than being so into the specific financials of the company.

Another situation that immediately comes to mind for me is during COVID.

If you think about all of the companies that did well during COVID it would seem pretty obvious:

  • Clorox – cleaning supplies
  • Zoom – Web meetings for everyone working from home
  • Domino’s Pizza – people can’t eat out so they’re getting delivery
  • FedEx/UPS – people are ordering more items to their house
  • Roku – people have nothing to do but watch TV and Roku is a premier streaming device

These all make sense, right?  Just as the companies that will struggle seemed obvious:

  • All retailers
  • Restaurants
  • Theme Parks
  • Sports Betting companies
  • Airlines

So, when COVID was really ramping up, did you think about this at all with your investing?  I’m not necessarily saying that you should’ve tried to time the market, but you could pick up on some of these trends and start to evaluate companies in these industries in anticipation that you might get some of these companies at a lower price.

For instance, if you loved Disney but didn’t want to pay the $140+ price tag in February, did you take the time to think about what price point you would be willing to buy it at?

I love the Value Trap Indicator because it will tell you if a company is a ‘Strong Buy’, ‘Monitor’, or ‘Strong Sell’, and it’s based off various things as well as the share price, obviously.  Well, you can change the share price to help show you when it might move to be a ‘Strong Buy’ and then use that as your purchase price. 

Doing this sort of analysis beforehand can help make you a super successful investor but it all starts with you thinking one or two steps beyond the normal sort of quantitative investor that you might be, and that I personally still struggle with at times.

Things always seem crystal clear after the fact but that’s the issue – it’s after the fact.  My recommendation to you is to try to take 30 minutes each week and just think big picture. 

Put your phone away and just go somewhere with a pen and paper and just think about trends occurring in the world.  Doing that can help spark some ideas of different companies that might make sense for you to take a look at or maybe industries that you can then dive deeper into for specific companies.

The thing is to challenge yourself to think beyond the simple valuation – we think big here – big baller brand.  Let’s go!