Even the best companies can make terrible investments if you overpay. A Yale study looking at market returns from 1881 to 2016 found that starting P/E ratio had a significant effect on total returns out to 30 years. What's more, in the past few decades, valuation has explained about 46% of the market's forward 5-year returns. Note that 1-year returns have little correlation to valuations because they are driven by volatile and often irrational short-term sentiment.
In other words, buy-and-hold investors can't just blindly buy great companies at any price but need to remember Buffett's famous quote, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
The corollary to that quote is what I call “the Buffett rule,” which is to never pay more than fair value for even the highest-quality companies. Doing so will lower your total returns, and since something great is always on sale, there is no reason to jump the gun on buying quality, low-risk dividend stocks.
After all, patience is the ultimate virtue of the long-term investor, because as Buffett also said, “the stock market is designed to transfer money from the active to the patient.”
But there's another reason why valuation is always worth keeping in mind.
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