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One of the most important lessons investors need to understand is that the price you pay for a stock compared to that companies earnings and book value is the most important factor investors can control affecting future income and returns. In other words, the valuation you pay for a company is very important.
The Two Brothers Who Love Coke
To make this point more clear I want to work through an example of two brothers who drink lots of Coca-Cola. These two brothers names are Larry and Oliver.
Ten years ago, Larry decided he loves Coke so much that he wants to invest $10,000 in the company. In January of 2002 Larry used his $10,000 to buy shares of Coca-Cola (KO) at a price of $43.75 per share.
Larry thinks Coca-Cola is such a company and people are going to be drinking Cokes and Diet Cokes for decades into the future. After buying his shares of KO, all Larry talks about with his brother is his investment. A few months pass and Oliver starts to get interested. Oliver then decides he’s going to buy $10,000 worth of Coke stock as well. He goes out in May of 2002 and purchases $10,000 worth of KO stock at a price of $57.64.
Now we have two very happy brothers excited for their financial future as they are sure the Coca-Cola company will deliver them riches.
Larry’s Investment at the Lower Price
Over the next decade, the Coca-Cola Company paid Larry $3,438 in dividend income for his portion of the earnings of the company. Larry could use this income for whatever he wanted such as travel, video games, fine dining or Coke beverages. Larry also still owned his KO shares at the end of December 2012 that are now valued at $16,573.50. Larry’s $10,000 of Coca-Cola investment has given him a total return of $10,011.50 or roughly double what he paid. His shares of KO are also currently paying him about $512 per year in additional dividend income. He’s pretty happy with his decision to invest in Coca-Cola.
Oliver’s Investment at the Higher Price
Oliver was a little late to the game so he purchased shares at a higher price than his brother. Over the next decade, the Coca-Cola Company paid Oliver $2,609 in dividend income for his portion of the earnings of the company. Oliver was able to use that income to buy new movies and his favorite Diet Coke beverage. Oliver also still owned his KO shares at the end of 2012 that are now valued at $12,578.75. Oliver’s $10,000 investment in Coca-Cola has given him a total return of $5,187.75 or roughly a 50% return over the years. His shares of KO are also currently paying him about $$388 per year in additional dividend income. Oliver is also happy but he doesn’t quite understand how his brother did so much better than him.
The Key is the Price
The difference between the two brothers investments is the price each paid for each share of KO stock. Larry purchased in at the lower price and therefore his $10k investment bought him 228.6 shares. Oliver waited and bought in at a higher price only giving him 173.5 shares. The reason Oliver’s investment didn’t fare quite as well over the years as his brother is because he paid about 32% more for his shares than his brother did. He paid a higher price for the KO stock which gave him smaller returns. He purchased less shares at the higher price which meant he was paid less dividend income over the life of the investment.
What Can We Learn from Larry and Oliver?
The lesson that every investor needs to understand is that the valuation you pay for a company has a huge impact over how your investment will turn out while you own it. The investor who buys in at lower valuations will always fare better than the investor who buys in when stocks are over valued. Buy low and sell high. Or for dividend growth investors, buy low and hold forever until the company becomes ridiculously overvalued or fails to increase it’s dividend.
Valuation is very important. These two brothers made the exact same investment just months apart from each other. The one who purchased at the lower price came out much better in the long run.
Currently we are seeing many dividend growth stocks have fairly high valuations compared to other opportunities available. The current valuations of some of the most popular dividend growth stocks are almost too high to offer reasonable expectation of good returns in the future. However, there are some out of favor companies that still over good value and have the ability to make investors very happy over the course of a long term investment. Investors would be wise to consider these lower valued options when trying to figure out what to invest in right now.
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