It’s obvious to most investors with any experience that they can’t justify buying an asset just based on the recent price action alone (technical analysis aside). You don’t buy based on price; you buy based on value. The price action means nothing without context. This point needs to be extended to multiples. When investors review stocks, they assign high multiples to companies expected to grow fast and low ones to firms expected to grow slowly. Every number when analyzing a firm has context. A software company is expected to have high margins because of its industry and a utility firm is expected to have a predictable earnings stream.
The key to understand is context isn’t a justification; it is an explanation. It’s ok to realize why investors expect something and then have a varying opinion. Context matters especially when you disagree with how an asset is valued because you can point to exactly where you think the market is wrong. We never know why investors are making trades because we can’t interview each one. That’s what makes context important. Anyone can look up the multiple a company trades at and analyze the expected cash flows. The important part is understanding why investors think the way they do. This part of investing takes experience with the company or asset to understand the tendencies and levers which matter.
Beware Of Anchoring Bias
Many bearish investors cite the CAPE ratio and the price to sales multiple as reasons to be negative without taking the analysis a step further to see why those metrics show those results. There is a fear of justifying high prices, but rest assured, we see the high numbers those stats show. However, no stat is right all the time. Secondly, if you act like those multiples are useful only because you just discovered them, you have an anchoring bias. Anchoring bias is when you focus too heavily on the first piece of information you see on a topic.
There are many points of analysis which project future returns based on current multiples. These types of charts are to clarify where stocks are expected to go based on the past; it’s far from a guarantee of where they are headed. Investing is much more difficult than following a metric and doing what it says. You need to get involved with the details to see why it’s priced where it is.
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