Does Price Actually Matter In Investing? (Yes, of Course It Does)
Updated: Sep 24, 2021
A popular investing strategy these days is to ignore valuation. You may think I’m joking, but there are thousands of investors out there who don’t think about the price they are paying when investing in marketable securities. Instinctually, this feels downright crazy, but guess what? The strategy has worked!
I’m of the camp that this is the bull market talking, and the numbers would look a lot different if valuation multiples didn’t expand (especially in the software/consumer internet sectors) significantly since the GFC. In my head, whenever another investor says “I don’t focus on valuation” I think, “Okay, then I’ll buy shares of your favorite stock on the open market, and immediately sell them to you for 10x what I bought them for. Becasue you don’t focus on price, right?”
S&P 500 P/S. Source: https://www.multpl.com/s-p-500-price-to-sales
A retrospective look
To try and confirm whether the ideas in my head are logical or not, I decided to run some math on the future investment returns one would have gotten if forced to buy shares in some of the largest companies in the world, but at 50x sales. To do this, I took the implied share price of the stock at various start dates if shares were trading at 50x sales (to neutralize change in share count) and calculated what the compound annual growth rate would be for investors through the end of 2020. The start year is as far back as I could find all the necessary data needed to make the calculations (it also ignores dividends).
Why 50x sales? Because it seems like half the time we do a Not So Deep Dive on a new software/consumer internet company, the stock trades at or near 50x the company’s trailing twelve month sales. Investors seem to be rationalizing paying 50-times (50!) a company’s revenue if they believe it will be a much larger and/or dominant global player a decade from now. But are they correct in doing so?
To keep the pool fair, I avoided low-margin businesses that would likely never trade at 50x sales, which would have muddied this half-baked “study” with unrealistic multiple compression. Except for Activision Blizzard (the only stock that would have had negative returns), all of these stocks trade at a P/S above 10x today.
Here are the results.
CAGR If bought at 50x sales (through end of 2020)
So, in order to get average market returns when buying stocks at 50x sales, all you have to do is:
Invest in a bunch of companies that will be the largest and most profitable in the world 15 years from now
Avoid picking any that won’t be (i.e. no duds or zeroes)
Sounds like a difficult game to me.
There is a huge difference between “paying up for growth/quality” and ignoring price altogether. Buying Facebook/Google/Mastercard/Visa at 20x sales (or 40x -50x trailing FCF, which is where they’ve spent a lot of time trading at) was a great bet last decade that lots of uptight value investors were afraid to make. But buying them at 50x sales? That is just taking the strategy too far. Unless you think the upstarts of today can be bigger and better than the ones listed above, why would returns from now through 2030 be any different for someone buying stocks that actually trade at 50x sales today?
If you base your investment decisions on estimations of future cash flows, then it should be obvious that the price you pay for that cash flow matters. If not, and you ignore the price you pay for a security, then all you’re doing is participating in a game of greater fool theory.
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Disclosure: The author is not a financial advisor. Brett Schafer and Ryan Henderson are portfolio managers at Arch Capital. Clients of Arch Capital may hold securities discussed on this post.