A company’s stock price can fall for multiple reasons, and knowing the reason for the dip can help you determine whether the stock is a buy at the dip. Some common reasons for a stock price dip are earnings misses, a panic sell due to overall market bearishness, the tax season sell-off, and periodic profit booking. These reasons do not affect the company’s business or earnings growth potential. As long as the reason for long-term earnings growth is intact, that stock is a buy.
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Importance of buying at the dip
Once you know which stock is a buy and for what reason, the next step is to look at its valuation. Sometimes, the bull market overvalues a stock as investors price in unreasonable growth expectations, as was the case with Shopify (TSX: SHOP) during the pandemic. Investors had priced in 10 years of growth between April 2020 and November 2021.
While the company continued reporting strong revenue growth for the following years, its stock price continued to fall for 12 months and has not yet returned to its 2021 peak. The valuation would have told you whether to buy the stock in November 2021 or November 2022. Even when Shopify was a fundamentally strong company with a bright growth outlook, the stretched valuations made the stock unattractive to buy in 2021. It is a stock to buy at the dip.
A Canadian stock to buy every time they take a dip
Constellation Software (TSX: CSU) is a resilient growth stock you could consider buying at every dip. The company operates like a private equity firm that acquires small vertical-specific software (VSS) companies for cash. It has stringent eligibility criteria for acquiring a company.
While Constellation is secretive about the eligibility numbers, it targets VSS companies that operate in a niche market and have a minimum recurring cash flow from mission-critical applications that are sticky. Moreover, the company should be available at an attractive valuation. It means the cash flows the acquired company brings in should give a certain percentage of return. Constellation reinvests the cash flows from acquired companies to acquire another company, giving you the advantage of compounding.
Whenever the stock market corrects, Constellation gets an opportunity to buy companies at a higher discount and increase their return on investment. However, the key to Constellation’s success is discipline. It does not make aggressive acquisitions or enter a bidding war, as that could hurt the returns of its overall portfolio.
This business model has helped Constellation grow its earnings per share (EPS) and free cash flow (FCF) at a 10-year compounded annual growth rate (CAGR) of 26% and 20%, respectively. Constellation stock is a buy because of its EPS and FCF growth through acquisitions.
When is a good time to buy Constellation stock?
Constellation’s share price has surged 293% in the last five years. Those waiting for the dip have missed this rally. It is because the share price generally dips 5-10%, creating a buying opportunity. The only time Constellation stock price dipped 15-20% is in a macro crisis, like the 2022 tech stock meltdown, the 2020 pandemic, or the 2018 U.S.-China trade war.
The right way to value a stock that grows through acquisitions is by looking at the price-to-earnings-growth (PEG) ratio. The P/E ratio will tell you the stock price as a percentage of the past 12-month EPS. This valuation works for companies that grow their earnings organically.
Constellation’s stock price depends on the EPS and FCF growth rate. The PEG ratio divides the P/E ratio from the EPS growth rate to give you the correct valuation. The company’s 2024 EPS grew by 29%. Assuming it can replicate this growth with the 2025 acquisitions, Constellation’s stock is trading at 3.25x PEG (P/E ratio of 94.4/29 EPS growth).
Now is a good time to buy the stock, as the 3.25 PEG ratio is lower than its three-year average PEG of 4.58.
