Valuation, Profitability, and Returns

There is much debate about buying "expensive" stocks. In short, many investors feel they should be avoided at all costs. Other investors choose to sell a stock when profitability slows, drops substantially, or is unprofitable. 

I believe that the chart above shows that selling simply based on valuation or declining profitability (or a company being unprofitable), one may miss out on tremendous gains. Many would consider NOW " expensive" at several points along the way, as the PS ratio hovered between 7-10. But buying at those levels delivered fabulous returns.

NOW experienced multiple drops profit margins (as well as spikes in valuation). But the stocks became a multibagger regardless of profitability challenges (unless on bought only around the peak of the Dot Com bubble or the 2021-2022 top).

The constant in the chart is that revenue continued to grow year after year. This is why some investors say that revenue growth is the most important factor in a stock's performance over the long-term.

 

In the INTU chart, we see drops and slow-downs in profit margin, price, and spikes in valuation. And still, INTU has delivered spectacular returns for long-terrm investors (525% over 10 years). Like NOW, INTU continued to increase revenue.

What one will see in both charts is that exponential gains in both price and valuation tended to retrace. In both charts, we see short-term retraces and long-term retraces. Price and valuation from 1999-2000 rose illogically high -- traders would buy anything with some promise or a clever idea, even if the fundamentals weren't there. But in 2022, many of the companies that retraced have solid, if not exemplary fundamentals.

In Summary

    1. A stock being expensive is not necessarily to related to future returns

    2. The same is true of declines in profitability and even unprofitability. 

    3. Revenue growth is often more important than profitability or valuation when it comes to achieving 

    superior returns

    4. Exponential gains in price and/or valuation tend to retrace partly or even completely.

Here is an example from the model portfolio.

CRWD's valuation and price grew exponentially and subsequently retraced. However, the revenue growth remains strong, which is one reason why I am bullish on CRWD.

This post does not come close to covering the intricacies and nuances of why these stocks moved the way they did. Each recession was different. But I believe the underlying principles above still apply.

As a final note. Dollar-cost-averaging can lessen the blow of buying at the top. One lowers their cost basis and may enjoy much of the gains along the way. If one bought NOW at the 2016 "top" and continued investing regularly, NOW provided excellent returns.

This website is created and authored by Marlin Sandlin and is published and provided for informational and entertainment purposes only and merely cites my own personal opinions.  I am not a financial advisor, and this website is not intended to constitute investment advice or provide specific advice or recommendations for any individual or on any specific security or investment product.  Any action you take upon the information you find on this website is strictly at your own risk.  This website may share links to articles and information which is interesting to me, but it is in no way an endorsement by me or by anyone associated with me.  The views reflected in the commentary are subject to change at any time without notice.   I may or may not hold investments in the companies or securities discussed on this website.

Marlin Sandlin owns shares of ServiceNow (NOW) and Crowdstrike (CRWD).