The Investment U E-Letter: Issue # 102
January 7, 2005 Stock Market Historical Performance: What's the Right Price for Any Investment?
By Dr. Steve Sjuggerud, Chairman, Investment U
The Caribbean Sea was particularly green this day, and there wasn't a cloud in the sky. It was perfect picture-taking weather off the coast of Belize. Unfortunately, I never got to see the pictures I took . . .
Long story short - my new Sony digital camera now rests on the bottom of the ocean somewhere off the coast of Belize. However, I did end up recouping a few of bucks from it . . . I still had the power charger to the camera back in my hotel room. It was now useless to me, but instead of throwing it out, I decided to find out if it had value to somebody somewhere. So I listed it on EBay. For a dollar. Much to my surprise, a bidding war broke out over this power cord. In the end, the winner actually paid $45 for it . . . which, it turns out, was a great deal for him compared to the manufacturer's price for a replacement charger. What Is the Right Price for Anything? It's what someone will pay for it, of course. I wouldn't have paid a dollar for that cable. But to somebody else, $45 was a great deal. So what's the right price for an investment? The quick answer is the same as above - what someone is willing to pay for it. Any other answer wouldn't be true. But we can better answer that question by looking at the stock market's historical peformance (more below) When you're investing, you're "laying out money today to receive more money tomorrow" (as Warren Buffett says in the current issue of Fortune). So if you lay out $5 today in exchange for a dollar a year over the next 10 years, you're investing. Or, to use another example, let's say you're considering a rental property, where you're laying out money today to receive more in the future. If the PRICE of a house you're considering is $100,000, and you're confident you can EARN $10,000 a year in rent after expenses, you're paying "10-times income," or "10-times earnings." But if the price of another house is only $50,000, and you could still earn $10,000 a year in rent, that would be a better investment. Why? The house would be paid for in five years, and all the earnings after that would be gravy. A house with a $50,000 price that earns $10,000 a year in rent is at a "price-to-earnings" ratio of five. Clearly, paying five-times earnings is better than paying 10-times earnings. Looking at how much you're receiving in earnings is one of the most time-tested ways to determine the "right" price of a stock (or at least the price you are willing to pay). Is the Market Overvalued? Look at the Stock Market's Historical Performance and Decide for Yourself… The historical performance of the stock market shows the average price-to-earnings ratio of the market has been 15.3 - which means that people have traditionally been willing to pay $150,000 or so for $10,000 in annual earnings. However, today, the price-to-earnings ratio of the stock market is 39.95 - meaning you would have to pay nearly $400,000 in investments for $10,000 in annual earnings. That's 161% higher than the historical performance average! Put another way, the stock market would have to fall over 60% before prices are back in line with the historical average value. Two other time-tested measures of evaluating a stock's performance also suggest that today, the stock market is significantly overvalued: 1. Price-to-Sales The price-to-sales ratio is comparing the price of a stock to the company's sales for that year. For example, WalMart's stock market value is about $250 billion, while sales over the last year were about $200 billion. So WalMart is trading at a price-to-sales ratio of 1.25. This means it's cheaper than most stocks today, but still expensive by historical standards. - 0.86 Historical Performance Average of the Stock Market
- 6.52 Current Value of the Stock Market
- 658% OVERVALUED
2. Price-to-Book Value The price-to-book value ratio is simple as well. Book value is synonymous with "net worth" which is assets minus debts (or what you've got minus what you owe). WalMart's share price is about $60, but it's book value is only $8. So WalMart's price-to-book ratio is about 7.5?expensive by any measure. - 1.94 Historical Performance Average of the Stock Market
- 4.88 Current Value of the Stock Market
- 152% OVERVALUED
How Relevant Are Historical Averages? What's interesting here though is that these measures of value have indicated stocks are "overvalued" for years. Like my worthless camera power cord, investors have bid up prices to extraordinary levels. Is my camera cable worth nothing . . . or $45? Is the stock market overvalued, as historical performance would suggest, or is it a good value? We can crunch as many numbers as we want to try to determine the "right" price to pay for an investment. But never forget this: the "right" price for an investment - its true value - will always be whatever somebody is willing to pay for it. TODAY'S IU CRIB SHEET - According to price-to-earnings calculations (one of the most time-tested methods for evaluating investments), the stock market is currently priced 161% higher than the historical performance average. In other words, in order for stock prices to reach traditional levels, the stock market would have to fall by 60%!
- History, of course, is a helpful guide to understanding the value of an investment . . . but the "true" price of any investment in a fair market is whatever someone else is willing to pay.
- Understanding the fundamentals of each stock you purchase is critical to your success. (Without this understanding, you're just "gambling.") One way to brush up on the "fundamentals" - and learn about proven strategies for stock market success - is to attend our Third Thursday - One Day Financial Symposium, January 17, 2002, in Orlando, FL. Call Member Services at 1-800-992-0205 or 410-223-2643 for more information today.
Good investing, Dr. Steve Related Articles The Most Important Lesson in Financial History | 
