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Question:


When investing, should you concentrate more on price or valuation?
-PeteD


Answer:


Price and valuation are essentially the same thing. When it comes to stocks, valuation is the price you have to pay for a certain amount of earnings or assets. If a company earns $2 a share this year and its stock costs $30 a share, then it trades at 15 times earnings, which is about the long-term average for the stock market. For bonds the price is what you pay to capture interest at a certain rate. A bond with a 3 percent coupon will pay interest at that rate if the bond trades at face value, typically $100. In a low-rate environment such as we have today, bond prices tend to rise, pushing yields lower.
 
Valuations are seldom studied in a vacuum. A stock may appear cheap if it trades at a low multiple of earnings or a low book value, which is the intrinsic net worth of the company’s assets. But if the rate at which earnings are expected to grow over the years is uninspiring, as it is with some utilities, then a low multiple may be justified. The same goes for a company whose prospects are diminishing. Some of the most overvalued stocks have been of technology companies whose products have been surpassed by newer, better, more popular ones.
 
 
Valuations in the bond market are often considered in the context of inflation expectations. Interest rates tend to be low in periods of low inflation, giving bond prices a boost. But if economists begin to forecast higher inflation, raising the possibility that the buying power of future interest payments and the original principal will be reduced, then bonds can suddenly seem overvalued.
-Conrad de Aenlle



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