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Paying a Premium

Successful companies don’t usually trade at a discount. They trade well above their book value and to own them you have to be willing to pay a premium, specially high flying tech companies such as Amazon and Alphabet. But the greater the premium, the greater the risk because you are less certain of its intrinsic value. That uncertainty will create more price fluctuations as the share price inflates. Take a look at the Amazon chart below. This is one of the hottest stocks in the Nasdaq, a favorite of investors and traders alike, and arguably one of the most successful companies in America. But look at the price fluctuations. The price of its shares fell from $2,000 to $1,300 in just four months in the second half of 2018.

The $700 drop in price was by no means a sign of trouble at Amazon. It was merely a reaction to the premium the market had placed on its shares. But if you bought the stock in late August of 2018, you were in for a very unpleasant ride, even if you were committed to holding the shares. For many, however, Amazon’s earning power justified the high multiple and the decline in price was seen as a temporary fluctuation—and an opportunity to buy more shares. But Amazon is a unique business and most companies don’t share its operational prowess and competitive advantages. That’s why paying a premium needs to be thought through carefully. Is the company immune to whatever is happening in the overall economy? Is it a dominant player? Will it continue to grow into the foreseeable future? Is the general market too expensive to justify buying at a premium? If you have doubts, then it’s probably best to buy when shares are lower. And never buy a stock immediately after its had a great run.


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