For a good company to be a good investment, it must be priced (valued) correctly.
Investors gain from a stock investment by buying at a price that is below the actual value. Over time, a good company will reward the investor with dividends and growth in the stock’s price. There is nothing wrong with wanting a piece of this type of company. The problem comes when you are a late arrival and the price of admission (stock price) has climbed too high.
Investors eager to get a piece of the action may bid up the stock’s price to a level where future price appreciation is uncertain. Too often, investors jump when they should stand back and take a hard look.
Ignoring dividends for a minute, you can get a rough idea of valuation by multiplying the earnings per share (EPS) by the price earnings ratio (P/E).
Remember P/E is a factor of how much investors are willing to pay for earnings.
So if a company is earning Rs. 10 per share and the P/E is 25, the stock should be worth Rs. 250 per share. If earning don’t change, but the P/E drops to 20 (meaning investors are not so excited about the company’s future prospects), the stock should now be worth Rs. 200 per share.
This is the problem of paying too much for the stock - if investor sentiment turns - the stock falls. Investors can’t predict what the market will do and how that might influence the stock’s price. Focusing on buying a stock at a discount to its worth as an operating company will help protect you from speculative influences on market price.
Of course, P/E is not the only or even the best measure of a stock’s true value, but it does illustrate why buying high is a dangerous strategy.
P/E Ratio - To determine relative value of Stock