Investing in the stock market is a multi-part process, although some investors see only one or two pieces.
The usual victims are investors who haven't done their homework or, more often, fall into the grips of the greed factor. Greed is one of the two main emotions at play in the stock market. The other is fear and is often characterized as the more powerful of the two.
When the stock market is on an upward trend and there is buzz in the news media about stock indexes rising, inexperienced investors feel tempted to jump in for some of the "easy money" being made on stocks.
Under these conditions, even a good company can become a risky investment.
Good company, but risky stock?
Like a smooth-talking brother-in-law who always makes his latest get-rich-quick scheme sound like a sure thing, good companies can be risky investments.
If the idea of a good company being a risky investment sounds incongruous to you, consider this scenario.
In 2012, Apple was a cash machine. Investors are dazzled by how the management is able to find new products that created markets and dominated them. At that point, Apple was well into the roll out of new iPhones and iPads introduced earlier.
Cash poured into the company and was turned into huge profits, quarter after quarter.
Naturally, investors want aboard this gravy train. To find a seat, they are willing to pay a premium.
There is nothing wrong with wanting a piece of this type of company.
The problem comes when you are a late arrival and the price of admission (stock price) has climbed too high.
At the beginning of 2012, Apple was selling around $411 per share. By mid-September, the stock nudged past $702 per share. However, as the market regained its senses, Apple fell to $532 per share.
Of course, the Apple story started long before 2012, but this one year was extraordinary and a good example of a great company whose stock became risky thanks to investors bidding up the price too high.
How high is too high?
That's a question that every investor must ask and answer.
Too often, investors jump when they should stand back and take a hard look.
Investors who have a chance for success look for good companies, companies that have superior management and consistently throw off earnings quarter after quarter.
But that is only half the work needed to find a good investment.
Good Company, Good Investment
For a good company to be a good investment, it must be priced (valued) correctly.
Investors gain from a stock investment by buying at a price that is below the actual value. Over time, a good company will reward the investor with dividends and growth in the stock's price.
If that is all there was, valuation would be much easier. However, there is another factor to consider.
Investors eager to get a piece of the action may bid up the stock's price to a level where future price appreciation is uncertain.
Remember P/E is a factor of how much investors are willing to pay for earnings.
So if a company is earning $2 per share and the P/E is 25, the stock should be worth $50 per share. If earnings don't change, but the P/E drops to 20 (meaning investors are not so excited about the company's future prospects), the stock should now be worth $40 per share.
This is the problem of paying too much for the stock - if investor sentiment turns - the stock falls. Investors can't predict what the market will do and how that might influence the stock's price. Focusing on buying a stock at a discount to its worth as an operating company will help protect you from speculative influences on market price.
Of course, P/E is not the only or even the best measure of a stock's true value, but it does illustrate why buying high is a dangerous strategy.