One of the golden rules of investing is to never overpay for stocks. There are plenty of good companies on the stock market, yet that doesn’t mean they are all good investments.

Overpaying for a stock greatly reduces the chances of the investment working out well. Over time a pricey company will revert back to a more normal valuation if its earnings, margins, opportunities and market position are average rather than superior.

You should only pay a premium valuation for a company that displays exceptional characteristics such as sustainable growth, consistent high levels of return on capital employed or a market position with considerable barriers to entry.

I appreciate many readers won’t be experts when it comes to valuing stocks. That’s why we regularly point out in Shares articles if something looks cheap, fair value or expensive. We also comment on whether a stock deserves a premium valuation or not.

Look beyond ‘the story’

Making a judgment on valuation is crucial when researching investments. Quite often I’ll hear about someone buying a stock because it made a profit last year and is forecast to make a bit more profit this year. Their ‘buy case’ may also be justified by the company operating in a trendy part of the market.

Sadly those two factors do not necessarily mean such a company is a good investment if it is already trading at a high valuation and doesn’t possess the aforementioned characteristics to justify a premium rating.

A relevant example is TT Electronics (TTG) which I met last week. At first glance it looked really interesting, particularly the promise of its emergence as a higher margin business now it has sold the transportation division which was the weaker part of the group.

TT’s management says the company has fixed some of the problems which have depressed performance in the past and it is now focused on opportunities in areas such as robotics, aerospace, medical devices and electrical items in the home.

‘This is a different business to what it was three to four years ago,’ says chief executive Richard Tyson. ‘It used to be an automotive play; not now. We’re an electrical component supplier, investing in future technology and enjoying a stronger balance sheet.’

Is TT worth buying?

The £366m business is certainly very interesting. However, Tyson’s revelation that margins are low and that TT is only in the top three to five market positions for its sectors (rather than a dominant player), together with analysis of financial ratios, makes me question whether it is worth buying at present.

The CEO says more work is needed to make the business a higher margin one. Stockbroker Peel Hunt forecasts TT will post a mere 6.4% operating margin in 2017 rising next year to 6.9%.

The stock trades on 20 times forecast earnings for 2018. That looks rich given the low margins – however, pre-tax profit is forecast to increase by 17% next year which is a positive, so too is a £57m estimated net cash position.

TT’s shares have done well in 2017 after going nowhere for years, reflecting the turnaround efforts. I’ll be watching this one closely to see how the company spends its cash and what those actions do for margins. For now, the price looks up with events. (DC)

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