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Tom Bradley is co-founder of Steadyhand Investment Management, a member of the Investment Hall of Fame and a champion of timeless investment principles.

Nvidia Corp. (NVDA-Q) reported its results recently and the numbers were eye-popping. Revenue for the third quarter was up 206 per cent to US$18-billion, and earnings per share were up more than 12 times, year-over-year. It was one of the most remarkable earnings reports I’ve ever seen from a large, established company.

So, what did the stock do? Well, it went down. I’m the first one to say that short-term squiggles in a stock price are meaningless, but this reaction was telling. It indicated that investors are factoring in even higher numbers in their valuation models and expectations for the company are sky-high. Nvidia shares are up more than 220 per cent year-to-date.

The stock’s reaction reinforced one of investing’s core principles: valuation matters. As Howard Marks, co-founder of Oaktree Capital Management, puts it: “No asset can be considered a good idea [or a bad idea] without reference to its price.”

There’s no doubt that what Nvidia is doing is remarkably. The question is, how much of its future success is already baked into the cake as far as its share price goes.

The link between how a company does and how its stock does is the price-to-earnings multiple (P/E), which is what investors are willing to pay for a dollar of expected future earnings. It’s the price tag on a stock.

The multiple paid will determine whether the stock price does better or worse than the underlying company. There are exceptions, but paying a multiple that is below a stock’s historical range may allow you to do better than the company. Paying above what it and other comparable companies normally trade at may lead to a disappointing outcome. Two examples from the technology sector, Apple Inc. (AAPL-Q) and Cisco Systems Inc. (CSCO-Q), illustrate this point.

At the end of 2019, Apple stock was trading at a multiple of 12 to 13 times earnings. The company was doing well, but investors worried about what would drive growth in the future. Fast forward to today, Apple’s earnings have doubled (although they’ve been flat for the last three years) but the stock is up over five times. The difference is the P/E has more than doubled to 30 times. It appears investors are rewarding Apple for its profitability and commanding market position, and worrying less about growth.

Cisco investors had the opposite experience. In 2000, the company was the dominant provider of plumbing for the internet (switches, routers) and the stock was trading at over 100 times earnings. Since then, Cisco has been immensely profitable (earning per share have grown 12 per cent a year on average) and the company has continually bought back its shares. The stock, on the other hand, is 40 per cent below its 2000 high. The multiple has been compressed to the mid-teens, overwhelming all the success the company has had.

As you can see from these examples, the link between a company’s fundamentals and its stock price is like an accordion. It expands and contracts, and is the reason why stock prices are far more volatile than earnings and dividends.

There are many factors that drive a stock’s return, but valuation is the most reliable one. Some may question this when looking at rocket ships like Nvidia, Apple, or Canada’s very own Constellation Software Inc. (CSU-T). Why care about the P/E multiple when these companies regularly blow through their growth estimates? There are two problems with this perspective.

First, in your investment career, you, or your investment manager, will buy many stocks over many years and unfortunately, the Nvidias are few and far between. Most often, you won’t know which ones they are until later. Second, when the growth comes back to earth, investors care a lot about the multiple.

Valuation is the closest thing we have to gravity in investing, but it’s not a tool for timing when to buy or sell a stock. Stocks can stay above or below their historical P/E range for many years. And there’s no doubt, being too stringent on price can cause you to miss a stock or wider trend that is in the early stages of a growth spurt. But valuation needs to be part of every investment decision. If you read a glowing report about a company that’s doing well, it’s incomplete if there isn’t a thorough analysis of how it’s being valued.

Think of valuation as a gut check. How much of the excitement you’re feeling is already reflected in the stock price? Is it reasonable to expect that the company can live up to the market’s expectations? Am I buying the next Apple or Cisco?

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 28/02/24 4:00pm EST.

SymbolName% changeLast
NVDA-Q
Nvidia Corp
-1.32%776.63
AAPL-Q
Apple Inc
-0.66%181.42
CSCO-Q
Cisco Systems Inc
-0.52%48.06
CSU-T
Constellation Software Inc
+0.43%3773.07

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