By: Dividend Sensei
As I write this the market is hitting yet another new record high. The S&P 500 is now trading at 23.0X forward earnings and is 39% historically overvalued. Many people worry that the market is overvalued.
They are correct.
Today I wanted to talk about the most important concept in finance, which has made and lost millions of investors fortunes over the years. Understanding and acting on this one simple idea could be the difference between retiring in splendor, retiring in comfort, or not retiring at all.
The Important Difference Between Valuation and Price
Warren Buffett once said, “Price is what you pay, value is what you get.” That’s absolutely correct. And in today’s stock market bubble this is a critical concept that many investors fail to consider.
Stocks are not simply letters and numbers on a computer screen. They represent actual ownership in real companies, which grow, thrive, struggle and sometimes die. The most basic concept in all of finance is the notion of intrinsic value or the true worth of a company.
There are few absolute truths on Wall Street. But one of these is that intrinsic value is based on the discounted earnings, cash flow, and dividends companies will generate in the future. Or to put another way, a long-term company’s fundamentals determine intrinsic value.
Since the stock price will always return to intrinsic value over time, if you know a company’s fair value, you can avoid costly mistakes. But more importantly make a fortune over the long-term.
Price Is What You Pay, Value Is What You Get
In the short-term, the stock market is often hilariously, and very profitably wrong about the value of a stock.
Studies show that just 8% of 12-month returns are a function of fundamentals. 92% are determined by luck. This is why I ignore 12-month price targets from analysts, which are just educated guesses about short-term sentiment.
Instead, I focus on the long-term fundamentals, which determine 91% of stock returns over time. Or to put another way, if you know a company’s fundamentals and intrinsic value, then long-term success is almost guaranteed.
The Long-Term Is Longer Than Most People Think
In the long-term 91% of stock market returns are a function of fundamentals. In other words, in the short-term luck is 12X as powerful as fundamentals. In the long-term, fundamentals are 11X as powerful as luck.
How long is “long-term”? The answer may surprise you. Based on numerous studies it turns out to be 10+ years, which is why stock market bubbles happen. People see a stock soaring for a few years and assume the market must be correctly pricing in its future fundamentals.
Momentum driven traders are often just speculating that the most recent trend will continue. Often these speculators are willing to pay absurd valuations for a popular company. All in the hopes that some greater fool will pay an even higher price later.
For months or even years, they can be right. But eventually, stock prices always return to intrinsic value. Embracing this concept can make you rich.
Even in This Market Bubble, Great Companies Are Always on Sale
In March 2000 the S&P 500 hit a forward PE of 27.2. This was the greatest stock market bubble in US history. It meant stocks were 66% historically overvalued. And over the next 10 years investors earned –1% annual total returns as a result.
You might imagine that there were no good investments you could make in the most extreme bubble in US history. After all, when even Coca-Cola (KO) was trading at more than 40X earnings, how could any investor find a good deal?
Great blue-chip deals are always available, no matter how overvalued the stock market gets.
- Berkshire Hathaway (BRK.B) was 50% undervalued in March 2000
- Realty Income (O) was 50% undervalued in March 2000. Its price to cash flow was 7X and it yielded a very safe 11%.
- Enterprise Products Partners (EPD) was 50% undervalued. Its price to cash flow was 6X and it yielded a very safe 12%
Prudent long-term investors who avoided paying crazy valuations for stocks didn’t just avoid the stock market’s “lost decade” they made a fortune.
- BRK investors who bought during the tech bubble low made 25.1% annually over the next 15 years.
- Realty Income investors made 17.7% annually
- Enterprise Products Partners investors made 23.8% annually
Smart long-term investors who recognized the difference between value and price during the tech bubble made 1,100% to 2,800% returns over the next 15 years. They literally achieved results on par with the greatest investors in history. More importantly, they locked in the kinds of safe, generous, and steadily growing dividend yields that rich retirements are made of.