This week we added Novo Nordisk to the portfolio, but there’s a problem.

If you’re not familiar with the company, Novo Nordisk is the leading provider of diabetes-care products in the world. The company manufactures and markets a variety of human and modern insulins, injectable diabetes treatments, oral antidiabetic agents and obesity treatments. Novo also has a biopharmaceutical segment that specialises in protein therapies for hemophilia and other disorders.

The problem is…

Novo Nordisk is very, very expensive. Maybe too expensive.

From the table, you can see that it trades at a whopping PE ratio of 42. It is equally highly valued on the price-to-cash flow and price-to-book ratios.

Did we overpay?

Valuation

On Friday in Copenhagen, Novo Nordisk was selling for about 690 Danish Krone (or DKK) per share, which is close to what we paid. But our spreadsheet valuation was only DKK 657. Uh oh!

We have just struck one of the great challenges of investing. Valuation seems like science because you calculate numbers in an Excel spreadsheet, but it’s at least equal part art. Over the years we have learned that you can get almost any number you desire out of a spreadsheet.

For that reason, it is best not to psychologically anchor on a number that comes out of Excel.

The Norm (not the guy from Cheers)

(Norm was a guy who sat at the bar counter in the 1980s sitcom Cheers)

If you decide that the spreadsheet number is THE number, you might find yourself unable to buy anything extraordinary.

The norm when doing a valuation is to plug numbers into your spreadsheet and come up with a valuation. Then you apply some arbitrary discount, say 15%. You do that because Buffett said we should apply a margin of safety. That gives you a maximum share price.

You then compare it to the market. If you’re lucky, the share price is below your maximum. If you’re unlucky, its above.

If it’s below, you buy the stock. Then the stock languishes and goes nowhere for a few months. Eventually you get impatient and sell the stock at a loss.

In the meantime, the other stock that was too expensive according to your spreadsheet has performed superbly. But you missed out. Now it’s even more expensive.

This is the dilemma that all investors face. The problem becomes even worse when you’re looking for extraordinary companies because they tend to be highly priced.

This is the challenge we faced with Novo Nordisk. The company is highly priced, more so after some price jumps this year. But the price we could buy it for was within 6% of our valuation, so we took the plunge.

Mitigations

How can you mitigate buying an expensive stock?

With extraordinary companies, one way is to give them time to do their magic. If the company is truly extraordinary and continues to perform well in future, the earnings and share price will continue their upward trajectory. That would be wonderful, but is in no way guaranteed to happen.

The other thing you can do is average your cost by purchasing shares over time. Some days, you will purchase them a high price, months later you might get them more reasonably.

Conclusion

In our case, we will either learn the lesson that overpaying for a stock makes for a bad investment or we will learn that our valuation was too low and be glad that we bought it.

Time will tell and we can learn this lesson together - thankfully, more cheaply for you than for us.

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