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When A Good Company Is A Bad Buy

Just because the earnings are strong, doesn't make a stock worth investing in, Real Money's Paul Price says.
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This holiday season, Paul Price likes to pose difficult questions to his Real Money readers. His latest is this: Can a company with attractive results be an ugly stock?

Why yes, he answers. As Estee Lauder  (EL) - Get Estee Lauder Companies Inc. Class A Report  has demonstrated lately, yes it very much can.

“Even the best companies can become so overpriced that there is little to no chance of making positive returns over anything but the shortest duration holding periods,” Price wrote recently on Real Money. “Cosmetics manufacturer Estee Lauder (EL) is a prime example. Since 2012, EL's sales, cash flow and earnings per share have all doubled or tripled. The annual dividend rate more than quadrupled.”

While those are impressive numbers, “they need to be compared with the stock's movement in relation to the value created. For Estee Lauder, the shares far outpaced that fine growth,” Price noted.

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“One of the big mistakes that investors make is that they confuse the strength of the company behind a stock with the value of owning the stock itself," Price added. "It’s an easy mistake to make because the two issues are highly related. Fundamental analysis is all about recognizing that each share of stock is a literal percentage of ownership in an underlying business, and an efficient market should price stocks based on what that underlying company is worth.”

However, “ as an investor, you make money based on how much your returns exceed what you spent to buy that stock in the first place (whether through capital gains or dividends). What’s more, you always have to measure an investment in terms of opportunity cost. For every $100-per-share stock you buy, that’s five $20-per-share stocks you passed up on.”

In the end, “a high priced stock might not have that much room to grow. Those prices might accurately reflect the strong company behind each share, but that doesn’t necessarily mean they’re good for your portfolio.”

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