Expensive Stocks - When is Paying a Lot a Good Thing?



Which is a better move, buying a hot stock at a high price or a low-cost stock that isn’t moving? You probably didn’t have any problem answering that one; it is better to over-pay for an expensive stock that is still going to make you money as opposed to a cheaper, unprofitable stock. First of all, no one wants a stock that isn’t going to make money, no matter the price. Second, buying an expensive stock is only a good move if the stock still has room to grow.

Looking at the Numbers

Consider two hypothetical stocks. Stock #1 is an expensive stock, showing a price to earnings ratio of 35 while stock #2 has a P/E of only 15. You might be tempted to conclude from this that Stock #1 is overpriced and stock #2 is a good deal. Since you are a good investor, you don’t look at just one metric but in this case, each metric you check says the same thing.

There are two false “laws" at work here that you need to recognize. First, not every expensive stock falls just because it has been rising; second, not everything that is down is going to rise. If you fall into the trap of these two thoughts, you might be tempted to buy stock #2 (and get a struggling stock) simply because of its position and ignore stock #1 because it is an expensive stock. It would be logical to assume that stock #1 is going to fall or at least drop back. It is over its value by all the metrics and near a one-year high. Stock #2 appears certain to climb, since it is clearly ready to be discovered by the market again.

Don’t Be Fooled

Just because a stock is cheap, it isn’t necessarily a good deal; conversely, an expensive stock isn’t necessarily a bad deal. Knowing what you know now, would you have bought Google stock when it was $250 a share? What about $300 a share? Those figures may have seemed sky-high before, but they are a good deal now that the price is hovering around $500 a share.

Buying Low

Buying low and selling high is the ultimate goal; however don’t get fooled. Just because a stock’s price has fallen doesn’t automatically mean it will rally. Those who are value investing successfully buy low and sell high but they are very selective about what they buy. The price of a stock is only one of many factors. The biggest is whether the stock has a chance of growing over time, regardless of its image as an expensive stock. In a down market, good stocks often take a beating, but investors shopping for bargains must look deeply past the stock’s price before making a buy decision.

Buying High

Looking at this example, buying expensive stocks is ok if you are confident the stock will continue to be a winning stock. A company that is growing by 30% per year with nothing stopping its progress is worth paying the going price, because the current price is probably the lowest it will be for some time.

You may wish you had purchased it six months earlier because of the stock prices, but that shouldn’t stop you from getting in if you have done your research. In addition, sometimes stocks just don’t drop. Even though many learned hard lessons when the Internet boom ended, stocks that are $20 per share and go to $100 per share don’t always fall back to $20. The price can have ups and downs, but a true growth stock will keep growing.

Conclusion

Buying expensive stocks seems like it goes against everything you have learned about investing in the stock market. Expensive stocks are a danger to the investor who doesn’t spend the time and research required to ensure the company is still on track to grow. An investor should use all of the tools available to determine if an expensive stock is still a good deal. In spite of the way it sounds, sometimes paying a lot can be a good thing!