Should I invest? What marriage can teach us about valuations.

Valuation is in the eye of the beholder...and beauty is only skin-deep.

Turn on CNBC, Bloomberg or pretty much any financial news network and you are bound to hear discussions of ‘a market top’, ‘v-shaped recovery’, ‘w-shaped recovery’, and the inevitable questions about a pending recession/correction. All of this leads to the inevitable question… ‘is the stock market overvalued?’ To answer the question, we must first ask ourselves, ‘can anyone truly value a single stock on the market?’

Like beauty, valuation is in the eye of the beholder.

How do people value the stocks that make up the market?

• Some use relative valuation, comparing one stock with others they find to be similar. However this is subjective as they ultimately choose which companies they are comparing.

• Some use discounted cash flow valuations, but those valuations always have some assumptions about future growth and risk free rates of return.

• Some rely on the market price and assume that the value of a stock is the price someone is willing to pay for it, but this approach means they’ve chosen to rely on others’ valuations which are subject to their assumptions.

• Some use technical’s, but reading charts is also open to personal interpretation.

All of this leads us to one conclusion — trying to figure out a ‘perfect’ stock valuation is impossible. This is a logical conclusion because buying a stock is buying a share of the current assets of a business along with an equal share of its future profits. Given that none of us can accurately predict the future, accurately determining a companies future profits is impossible.

So then going back to the theme of this post…is the market overvalued?

If it’s not possible to perfectly known the valuation of a single stock, logically it’s not possible to know the fair valuation of an entire market of them.

This begs the question, how do I know when to invest?

Consider lessons we can learn from one of life’s most important investments….marriage. Marriage is an investment unlike any others. It’s a lifetime commitment, to buy or sell it has extreme financial and emotional consequences, and no amount of money could ever match the return that a successful marriage generates or undo the regret that a terrible marriage can leave behind. Yet how does one successfully evaluate a potential marriage mate?

Researchers have discovered that a successful marriage is based on a number of factors, but among the most important are mutually shared values, a deep sense of commitment and a mutual willingness to overlook the imperfections of the other person. While attraction is important, beauty is only skin-deep.

An investment shouldn’t be too different. Ask yourself…do I understand what I’m investing in? Do I genuinely believe in the management’s vision for the company? Am I committed to weathering the highs and lows of the market with this company? These are important questions to ask yourself, because they will help you from selling a stock when it has a correction, or worse taking profits far too soon. Just because we like a company, doesn’t mean we should invest in it. If you don’t have the conviction to stick it out when the market thinks you’re wrong, you probably shouldn’t invest in the company.

Even if you can truthfully answer yes to all these questions, there is still one more lesson you can learn from marriage. The #1 reason of fights between newlyweds is finances. Money can’t buy happiness, but indebtedness and insolvency can strain even the happiest of relationships. A shrewd person looks at their finances before contemplating marriage. A shrew investor does the same.

Before investing you need to ask yourself about your finances. Are you ready? Can you afford the ups and downs of this commitment? Now ask yourself the same question about your possible partner (investment). What are their finances? Can they weather a storm in the economy? What can they contribute to the relationship? Do they promise an excess return at some point on invested capital? Will the potential amount of this return, exceed the cost of the investment? Is this potential return worth the risk?

A word to the wise — be careful about how you project future earnings. Just like in love, in investing and in valuation, we tend to see what we want to see. That cute girl, she’s not THAT self-centered. The guy with the biceps, he’s not THAT rude. The sexy new IPO it’s not THAT far from being profitable. At the same time don’t fall in love with the past. People change, businesses change. Take each one with a grain of salt.

Evaluating potential investments from different, objective angles is the only way to properly invest. Take the time to see if your beliefs and convictions about the future match the company you want to invest in. Take more time to understand exactly what they do. Yet still, take even more time to analyze the finances of both parties.

Just like in love, not every investment will be a winner, and that’s okay. Because finding the right investment is well worth the patience, time and effort you spend in analyzing the business, analyzing yourself and analyzing the finances.

An article I once read on marriage said, when you meet the right one, the more you get to know her, there comes a point where you just know she’s the one. After a number of failed relationships, I did come to that point in life where I just knew my wife was the one. In investing there will be moments after doing your diligence that you’ll just know you want to be invested in a company. It’s not a guarantee for success, but it’s a solid way to look at potential investments.