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Buying High Price Stocks
Is the high price of a stock an indication that more growth in those earnings has already been discounted in the price?
There is one very expensive mistake in investment thinking that happens so frequently that it is worth mentioning. In order to explain it we will go back to using our fictitious 123 Corporation. This is a corporation that has done very well as far as all the investment rules are concerned for a good number of years now. 123 Corporation has also had continual growth in both sales and profits for over twenty years and there have additionally been sufficient new products that have been getting developed to in order to furnish a good suggestion of comparable growth in the period that is coming ahead. This company has a good reputation throughout the financial community. As a result for years the 123 Corporation has been able to sell close to thirty times current earnings.
There is one very expensive mistake in investment thinking that happens so frequently that it is worth mentioning. In order to explain it we will go back to using our fictitious 123 Corporation. This is a corporation that has done very well as far as all the investment rules are concerned for a good number of years now. 123 Corporation has also had continual growth in both sales and profits for over twenty years and there have additionally been sufficient new products that have been getting developed to in order to furnish a good suggestion of comparable growth in the period that is coming ahead. This company has a good reputation throughout the financial community. As a result for years the 123 Corporation has been able to sell close to thirty times current earnings.
Now the stock of this company is two times higher than in relation to every dollar it is earning. The management of 123 Corporation has also just issued a prediction and indicates the company is expecting to double its earnings within the next four to five years. On the basis of what has been announced about the corporation, it all seems like a convincing forecast.
At which point an impressive amount of investors then jump to conclusions that are not real. It is said that since this corporation is selling two times as high as the stocks in general, and due to the fact that it is going to take anywhere from four to five years for the earnings of 123 Corporation to double, the actual price of 123 stock is reducing the future earnings ahead and they are convinced that the stock has been over priced.
It is very easy to agree that a company that is discounting its earnings four to five years ahead is most likely over priced. However, the mistake in the minds of the investors is in assuming that in a few years from now 123 is going to be selling on the same price earnings ratio as the general stock that it is compared with. For over twenty years, due to all those features that make this an exceptional company has been selling at two times the price earnings ratio of other stocks. The documentation has been gratifying to the people that have put their trust in it. If the company keeps on following along with the same policies, within four or five years from now its management will bring out yet a new group of products that within the following few years will inflate earnings in the same manner that new products are increasing earnings at the moment and that others did twenty years ago. If this takes place, why should this stock not sell for five years for two times the price earning ratio of these more normal stocks in the same way that it is doing currently and has been doing for the past years? If the company does do this, and if the price earnings ratio of all stocks stays the same, the two times of 123 in the next four to five years is also going to cause its price to have gone up two times over this five year time. With this base, it cannot be said that the company is discounting earnings in the future at all with this stock that is selling at its normal price earnings ratio.