In the investing world, much is said about valuaton. So what is valuation?
The simple explanation is that valuation is the determination of the worth of an investment. The worth, or value, of an investment can be determined in any number of ways. If one uses consistency in measuring more than one asset, there is a hope of some expectation of evenhandedness.
Valuation could be considered more an art than a science. There are well known measuring formulas, some of which are widely available in the financial press, and others can be esoteric or proprietary.
So valuation is one of those things that seems important, unless it isn’t. If I wanted to hold a stock for a long-term investment in the hopes of selling it one day for a profit, then valuation is something I would look at. Valuation in such a situation seems a potential measure of future profitability. If I pay a high price, then my upside is possibly limited. If I pay a low price, then I have a higher potential upside. In this definition, a “high price” and a “low price” means a price relative to the potential growth aspects of the company in question. Am I paying a high price for the company’s earnings, or a low price? That is why the simplest valuation measure is called P/E Ratio (price/earnings ratio), namely the relationship between the price I am about to pay for each share and the earnings for each share.
So are they important?
The answer is Yes and No. They are as important as the person making their decision as to whether to invest or not. Some investors will never consider investing in a stock if their preferred valuation measure does not meet their own criteria. Since investors all have their favorite valuation tools, opinions will obviously vary.
Time
In my view, one’s time horizon is a major deciding factor in using valuation. For a trader who buys and sells frequently, valuation by many standard measures may be irrelevant. For an investor who wants to buy and hold for the longer term, valuation may be significant if not the deciding factor. And for those building a legacy for their heirs, valuation may be of no interest whatsoever.
In my view, anyone who inherits stock, especially for the dividends, will never say, “Oh, I wish my uncle had bought this stock at a lower valuation.” What they will be is grateful they now own it at all. If anything, they will wish there was more, regardless of the original price.
Your take on valuation? Let me know here.
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