The other day i was talking to one of my friends about stock market investing. He seemed to be pretty excited about lessons he learnt in his Finance 101 class about cash flows, dividend growth, etc. ..He said i am going to invest in this company X. Its a market leader in its field, has a strong brand recognition, its earnings are forecasted to grow N times and therefore its stock is worth investing in. You might say well my friend is making a correct decision with his investment.
Well, he might or might not be correct. I said to myself, He might make a VERY BIG Mistake. Why? Simply because of the fact that the stock of a good company need not always be a good investment. You may ask why? Whats wrong with investing in such a company. Because the stock might be over-valued in the market !
The biggest mistake that investors make is failing to differentiate between good companies and good stocks. Take the example of GE or e-bay. It is a good company but has been always over-valued. Its earnings have grown by leaps and bounds since the 90s but its stock price has roughly remained the same since then ! It would be so much frustrating to see no growth in your investment all these years. Or consider Microsoft and Google. Everybody knows these are excellent companies. But are their stocks worth investing in?They may or may not be. If you think their stocks are great investments at any price, you might be in trouble.
Here comes the emotional aspect of investing. Investors tend to overestimate the performance of good companies thereby driving-up their price to ridiculous levels.
They fail to realize that good investment is a product of fundamentals (cash flows, earnings growth, etc) and valuation (P/E, P/CF ratios, etc) . If you invest considering only one factor, you are at the risk of a loss.
Benjamin Graham had once said "Price is what you pay. Value is what you get".