Why Good Companies Do Not Always Make Good Investments

by Hank Coleman

Good companies may not make good investments.There is a difference between a good company and a company’s stock that makes a good investment. How do you choose and know when a good company may be a poor investment choice? How do you keep from falling in love with a company? These are some of the tricky questions that individual stock investors wrestle with.

Here are a few things to consider when trying to identify when a good company may be a bad investment.

The Right Stock Valuation

Classic finance theory states that the valuation of a stock price over the long-term is based on the current value of its future earnings (cash flows). So, what does that even mean? It means that a company’s individual popularity unfortunately does not always translate into higher share prices. Wildly popular companies can have next to no profits. Just look at the earnings of internet companies like Facebook, Yelp, Groupon, and the like. Far too often, they are more popular than profitable.

The Amount Of Common Stock Float

There is a reason that companies buy back their shares. When a lot of common shares are floating on the open market, each shareholder’s stake is smaller than it would be if fewer shares exist. For example, if there are 100 million shares on the open market available from a company who earned $10 million in profit, each share has claims to $0.10 of that profit (10/100 mil).

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If the company reduced the number of shares on the market with buybacks, each shareholder’s slice of the pie would increase. If that same company bought 20 million shares and took them off the market, each shareholder would then have 16 cents worth of the yearly profit for each share owned (10/80). That equates to a 60% increase in each shareholder’s stake in the profits.

What does this have to do with good companies and bad investments? Just take Facebook’s recent IPO as an example. In the last few days leading up to the initial sale of shares, Facebook increased the number of shares that they were issuing to a whopping 410 million from 380 million which diluted each individual shareholder’s future stake in the company by almost 10%. That doesn’t bode well for a stock that was already priced high relative to its earnings.

Stock Structure Can Affect Price

A lot of hoopla has been written about Google issuing a new class of shares of their common stock. The new shares of stock diminish shareholders’ voting rights in favor of the company’s founders. The shares have dramatically less voting rights than original shares owned by the founders which keep over 50% of control of the company solely in their hands. While this is not always a big deal to many small investors, it is something to consider when buying shares of a good company that may make it not so desirable a stock over the long-term.

What Is There Business Model?

At the end of the day, you have to understand how a company earns revenue and makes a profit. A company cannot and should not be valued solely based on how great we think it is. The company has to show tangible results to warrant higher valuations.

There are many reasons why good companies do not have successful stocks with share prices that continue to rise. It is not because they are bad companies or doing things necessarily wrong. Instead there can be a host of reason such as too many common shares on the market, poor share class structure, valuations not based on earnings, fad popularity, unclear business models, and the list just goes on and on.

I have a bad habit of falling in love with companies and brands even though at times they make for horrible stock picks. A classic example is my love for Dr. Pepper Snapple Group despite the possibility of better choices in the beverage market.

What about you? Have you ever fallen in love with a company only to be burned by their stock?

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About Hank Coleman

Hank Coleman is the founder of Money Q&A, an Iraq combat veteran, a Dr. Pepper addict, and a self-proclaimed investing junkie. He has written extensively for many nationally known financial websites and publications. Hank holds a Master’s Degree in Finance and a graduate certificate in personal financial planning. Email him directly at Hank[at]MoneyQandA.com.


Hank Coleman has written 578 articles on Money Q&A. Learn more about Money Q&A on Twitter @MoneyQandA and @HankColeman.


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{ 11 comments… read them below or add one }

Jai Catalano

FB isn’t a good investment. There I said it. I know I am not the only one who has… but when I found out that someone I know got burned on the IPO it makes me wonder wtf are you doing.

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Elizabeth @ Simple Finance

I’m pretty traditional and conservative with my stock selections. I get it largely from my dad. He has a theory about cars – never buy a car in one of its first five model years. Why? Because it hasn’t been tested yet. I apply the same theory to stocks: I’ll never buy stock in a company that hasn’t been around at least a decade. Why? Because I need to be positive it’s not just a passing fad.

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Hank Coleman

That’s a great point. I bought a car the very first year after it went through an complete overhaul in body style and components. It was definitely a mistake with a lot of recalls and issues.

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Modest Money

Good points Hank. This is why it’s important to invest with our brains and not with our hearts. I like Elizabeth’s strategy of avoiding untested stocks. You might end up missing some big opportunities that way, but you avoid the companies that grow too fast to keep up the momentum.

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Hank Coleman

It is definitely a trade off that you have to make. Are you okay with missing the big ones for slow and steady growth? Most people say yes, and the rest of us buy shares of Facebook.

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Eric J. Nisall - DollarVersity

I like the old adage about buying companies whose products you use, understand, and trust. It’s difficult to really get a grip on the entire business model of a Facebook or Groupon for many folks. On the other hand, lots of people know what Coke or Pepsi make, and like it so it’s easier to understand and invest in them.

Of course, there are always irrational reactions to news that cause panic and sell-offs even if the company is strong long-term. It’s just one of the many risks you assume when investing in the market in general.

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Hank Coleman

Eric,
You are absolutely right. I find that more and more people jumping into investments based solely on short-term news from TV reporters who are hyping it up.

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Online pay day loans

I believe the Facebook stock is way over valued and the only people that are going to make money on it are the people who had shares before the company went public.

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Brian Johnson

The initial decline in FB stock should not be a surprise. Senior management and the board of directors are more knowledgeable than outside investors about the prospects for the company and about the appropriate value of the company’s stock.

When companies sell additional equity shares or go through an initial public offering (FaceBook shares down 10% yesterday and another 6% so far this morning – ouch!), it signals the stock is potentially overvalued.

Having specific buy and sell rules can remove emotion from the investment process and help investors avoid rushing to buy the latest stock like FB. By typical valuation metrics, FB stock was overvalued at the IPO price.

FB stock may do well in the future, but their earnings will have to grow significantly to catch up to their valuation.

Brian Johnson

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Penny Stock Blog

An excellent point can be made when it comes to value stock investing. A value investor is always looking for bad news about a good company because they know that the less they pay for a decent company the more money they stand to make when that company regains its old form.

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Ken Faulkenberry

Investing is not always easy because you have to do your research and only buy good companies at the right valuation level. Patience is a virtue! Thanks for the excellent points.

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