Investors often erroneously assume that a great company translates into a great investment. We discussed several ways to identify superior businesses, but we did not bring up valuation. Finding strong companies is crucial in the investment process, but it is equally important to determine what those companies' stocks are actually worth. Your goal as an investor should be to find wonderful businesses, and invest in them at reasonable prices. If you avoid confusing a great company with a great investment, you will already be ahead of many of your investing peers.
Suppose you are buying a car. Before you make a purchase, you will probably want to do some research, identify a few promising candidates, and take each for a test-drive. But throughout the process, you will also be aware of price. After all, you would not pay $50,000 for a used clunker, though you might pay that much for a new luxury car. Likewise, you would probably never spend $200,000 on a car, no matter the make.
The same thing should be true if you are thinking about buying a stock. A company's profitability, growth prospects, quality of management, and competitive advantages vis-a-vis its rivals are all important factors to consider. However, even the greatest company in the world might not be an attractive investment if its stock is priced too high. The price you pay for a stock can have a significant effect on your returns, and it can mean the difference between a good investment and a mediocre one. (Or worse!)
Why Valuation Matters >>