Are you an equity investor?
Do you pick stocks of companies offering great products?
If yes, then this article is especially for you to think about your purchasing decision twice!
Most of stock market investors pick stocks of businesses which offer a great product. They believe that like the product offered, their stocks will also boom in future.
Trust me, this is not true.
In this article, I will explain reasons with examples of how businesses with a great product may not be a great stock to buy.
In this article
1. A great product does not have to generate great revenue.
A great product does not have to generate great revenue.
Think about it, you can make more revenue selling 1 million bottles of water for Rs. 10, than selling 1,000 bottles of water for Rs. 500
Great revenue does not have to mean great profit.
Even if you can sell 1 million bottles of the ₹1,000 water, and the production costs you ₹1,200/bottle, you’re losing money.
Great profit does not mean great stock market performance.
Expected profit is already built into the stock price. If you are expected to make ₹1 billion selling lots of high-quality wine, and you actually make ₹999 million, that’s still a very profitable business, but the stock will go down.
2. At high valuation, even a great business is a bad investment
While a firm’s high valuation influences the stock price, it shouldn’t be the only factor you consider while choosing a scrip. If the stock price is high, the high growth may already have been factored in.
It’s the entry point that is crucial to generating good returns. A lower entry price is likely to yield more upside and to a degree, reduce the risk of loss.
Timing is everything in equity investing. If one invests at a high price, even a good quality stock may not yield much.
The PE multiple is typically used as a screening criterion to identify cheap stocks. Used at the broader index level, it signifies how cheap or expensive the market is at that point and is a clear indicator of the investor sentiment.A low valuation shows that investors are fearful, while high valuation signifies optimism, even greed.
In case of the former, firms typically trade much below their fair values, while in the latter, they trade above their fair values.
In the long run, broader markets cannot remain overvalued or undervalued. They tend to move towards fair value.
So, investments in difficult times (lower PE) have a higher chance of generating returns and a lower probability of loss.
3. A stock embeds its future expectations about the company’s cash flow stream
A business with a great product may not guarantee the company’s future cash flow stream but stocks act according to it
Imagine two companies:
1.Company A produces ₹1 per share per year in Free Cash Flow and is expected to do so in perpetuity
2.Company B produces ₹2 per share per year in Free Cash Flow and is expected to do so in perpetuity
Let’s say each company’s stock was priced so that investors would receive a 10% rate of return. That would mean that company A would be trading at ₹10/share and company B would be trading at ₹20/share.
Now, imagine that a new development comes to pass that causes company B to make ₹1.50/share in Free Cash Flow in perpetuity, instead of the previously expected ₹2/share.
Assuming investors still want the same 10% rate of return, its shares would decline from ₹20 to ₹15 – a decline of 25%.
Notice that Company ‘B’ is still making more per share than Company ‘A’, but Company ‘A’ stock in this example would be flat while Company B’s would be down by 25%, because expectations about the future is lowered and not because it is a worse company.
Separating good companies from bad ones is easy, determining whether companies are well or badly managed is slightly more complicated but defining which companies are good investments is the biggest challenge.
Companies with great product can be terrible investments if purchased at too high a price that embeds unrealistically high expectations even if the business itself performs quite well.
Disclaimer: The views expressed in this post are that of the author and not those of Groww