In general, if you can buy a quality stock today for a historically fair price or fair P/E, you should probably do so, provided the reward and risk are attractive.
However, what should you do if you find that the price or P/E is significantly above or below the historically fair price or fair P/E mark?
A low price or low P/E is probably your biggest concern, because it suggests that people who are buying the stock today might know something negative about the company that you don't know.
Think about it. Why would investors pay less for the stock than it has typically sold for?
- Is there something in the news that you haven't heard about?
- Has an analyst - or have a number of analysts - announced a reduced expectation of future earnings based upon something they know that you don't know?
- Have you missed something in your quality analysis - or (shame on you!) recklessly jumped over that barbed-wire fence, failing to evaluate quality deliberately enough before moving on to look at the value considerations?
If the price or P/E is too low - move on to another company and forget about looking at the risk and reward. You may miss a few good stocks, but you won't have to lose any sleep worrying about being wrong.
If the price or P/E ratio is too high, this tells you two things.
- The first is that other investors appear to agree with you about the quality issues, because they are paying a healthy price for the stock.
- The second is that it may be too healthy a price.
- You may want to put off buying it until the price becomes more reasonable.
- Or, it may be worth the premium if the risk and reward are satisfactory.
Just know that, if you buy a stock whose price or P/E is too far above the fair price or fair P/E, when it later comes back down - which it usually will - the decrease in P/E can reduce your gain considerably. Your chances of having a superior portfolio are far better if you select stocks for which you don't have to make any allowances.
As you gain more experience, you'll find that you can make some intelligent exceptions in cases of high or low price or P/E, but for now, the advice for those who are just starting out, don't.