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Why You Shouldn’t Overpay for Any Stock

Some say that you don’t have to worry about what price you pay for a stock if you have many years for your investments to grow. However, that is far from the truth.

Think about the Internet bubble in which many technology companies’ prices skyrocketed. In fact, after almost 16 years, Microsoft Corporation still hasn’t recovered to the high it had during the bubble.

That is an extreme case, but it doesn’t change the fact that it takes time for business performance to catch up to an elevated stock price. While playing catch up, the stock price can go nowhere.

You should try to pay a reasonable price for every stock. In fact, you should try to buy stocks at discounts.

Slower earnings growth

Imagine you bought a stock at a high multiple. If the stock’s earnings fell, its multiple would contract, and you’d see the price go sideways, or worse, fall.

For example, Canadian National Railway Company (TSX:CNR)(NYSE:CNI) traded at a multiple as high as 22 in 2014. Arguably, it justified that multiple because in 2014 its earnings per share (EPS) increased by 23%.

But could it deliver earnings growth of 20% or more year after year? This year, it’s anticipated to grow earnings by about 17% and by about 7% next year. The further out into the future, the more inaccurate that estimations are.

However, the railroad business is cyclical, so there will be times, such as now, when its earnings growth will slow down and its multiples contract until things turn around again.

Earnings could fall

Falling earnings is worse than slower earnings growth. Early in the year, Canadian Utilities Limited (TSX:CU) traded at a high multiple of 19, while it actually posted negative EPS growth in 2014.

This year the utility’s EPS is expected to retreat as much as 13%. That’s why this year, Canadian Utilities’s stock price has been in a general downtrend. So, it’s safer to buy stocks at a discount. Even when a business has a bad year, you’ll still have a margin of safety from your discounted purchase.

The good news is that lower prices imply higher yields. Canadian Utilities yields 3.7% at about $32 per share compared to a yield of 2.8% when it traded at a multiple of 19.

Usually, companies with track records of growing dividends and safe payout ratios will continue paying their dividends. Canadian Utilities has increased its dividend for 43 consecutive years, and it should be increasing it soon in the first quarter of 2016. Its dividend is safe because it has a payout ratio around 50%.

Conclusion

If you expect earnings to grow at a slower pace or even fall for any company or industry, wait before investing. You don’t want to overpay for any stock because it takes time for even the best of businesses to catch up with higher earnings in the future.

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Fool contributor Kay Ng owns shares of Canadian National Railway, CANADIAN UTILITIES LTD., CL.A, NV, and Microsoft. David Gardner owns shares of Canadian National Railway. The Motley Fool owns shares of Canadian National Railway. Canadian National Railway is a recommendation of Stock Advisor Canada.

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