When investors discuss stocks, one topic never stays away for too long, i.e., valuations. Terms like “overvalued,” “undervalued,” “high P/E,” or “cheap stock” often dominate the conversations. Many investors become so focused on valuation metrics that they end up believing buying a low-valued stock automatically increases the chances of making money.
But have you ever thought: does valuation alone really determine your investment success?
The answer could be complex. Valuations matter, but perhaps not as much as many people think. Over long periods, earnings growth often turns out to be the bigger driver of wealth creation.
The Valuation Trap
A common mistake investors make is assuming that a stock trading at a lower valuation is automatically attractive.
Imagine two companies:
Company Abc trades at 10 times earnings and grows profits at 5% annually.
Company Xyz trades at 40 times earnings but grows profits at 25–30% annually.
At first glance, Company Abc looks safer and cheaper. Many investors would immediately lean towards it because paying lower prices feels more comfortable.
It is evident from the history that stock markets reward future performance and not today's price tag.
For example- Nestle India Constantly trades at a PE of around 75 showing as overvalued, but it has given consistent returns over the last 20 years starting from 2016 showing a Compounded Return of above 15% year over year despite its constant high PE.
This means if Company Xyz consistently grows earnings at a much faster pace, its profits could multiply several times over the next decade. As earnings rise, even a stock that initially looked expensive may eventually become reasonably priced or even cheap in hindsight.
History repeatedly shows that many great businesses looked expensive almost all the time, such as the story of Nestle India described above.
Investors often avoided them because the valuation was too high. Years later, those same stocks multiplied several times over.
Earnings Growth: The Real Engine
Think of a company as a machine that produces profits.
Valuation determines the price you pay for the machine today. Earnings growth determines how much more productive that machine becomes over time. If the machine keeps increasing output every year, its value naturally rises.
This explains why many market leaders maintain higher valuations for extended periods. Investors are not simply paying for current earnings; they are paying for future growth potential. A business growing earnings at 20–25% annually can create enormous shareholder value, even if investors initially pay a premium.
Over long periods, stock prices usually follow the company’s earnings growth.
Price may move randomly in the short term. Emotions, news, interest rates, and market sentiment can create temporary distortions. But eventually, business performance tends to catch up.
Why Valuations Still Cannot Be Ignored
This does not mean valuation should be thrown out of the window. Even a great company can become a poor investment if purchased at irrational prices.
Suppose a company is growing earnings at 20%, but investors become excessively optimistic and start paying 100–120 times the earnings. The expectations become extremely high. Even if the company performs well, it may struggle to justify those valuations.
The result can be years of mediocre returns despite solid business growth.
Hence, the Valuation acts more like a risk management tool rather than the primary investment research. It tells you whether you are paying a sensible price relative to the expected growth.
Growth at a Reasonable Price
Successful investing often lies somewhere in the middle.
Buying poor businesses just because they appear cheap can become a value trap. On the other hand, blindly paying any price for growth can also lead to disappointment.
The ideal situation is identifying businesses with:
- Strong and sustainable earnings growth
- Competitive advantages
- Good management quality
- Reasonable valuations
Notice something important here? Growth comes first, valuations come later.
Summing Up
Many investors spend too much time researching, "Is this stock expensive?"
A better question could be: "Can this company continue growing earnings at a healthy pace for many years?"
Valuations matter. Ignoring them entirely would be risky. But wealth creation in stock markets has historically been driven more by businesses that consistently expand profits than by stocks that simply looked cheap.
A cheap stock can remain cheap for years.
A growing business, however, has the ability to change the entire equation.
And in investing, earnings growth often writes the story while valuations only influence the opening chapter.
