What gives? In retrospect, almost every professional investor agrees that stock prices at the end of the last millennium had become totally detached from economic reality. Coca-Cola had a price-to-earnings ratio (p/e ratio) of 50 (giving it an earnings yield of only 2%; in other words, you could have bought a risk-free United States Treasury bond with an absolute guarantee of payment and earned twice as much profit).
Typically, when a stock becomes overvalued, the situation can be corrected in one of two ways: either through a drop in the share price or through the equity price stagnating until the intrinsic value can catch up with the market value. Home Depot, for example, traded as high as $70 per share and the stock has fallen as far as below $33 despite a near-tripling of the dividend, a doubling to tripling of the profit, and a $14 billion share repurchase plan (for the whole story, check out Why Home Depot Shareholders Have Lost Their Minds). Wal-Mart is another good example. Since 1999, the company has increased diluted earnings per share from $0.98 to $2.68 and cash dividends from $0.16 and $0.60, respectively. Yet, as of today, the stock price has gone from $70.25 to $43.02. (Still, long-term investors should take solace in the fact that despite paying out large cash dividends along the way, the retailing giant’s shares are up more than 100,000% since the initial public offering!).
How You Can Profit
As more and more earnings power and cash flow builds up behind these shares, and they continue to fall in price, good investors are likely to begin salivating at the prospect of buying some of America’s best companies at prices that simply haven’t been available in the past. At some point, Wall Street will take notice; history has born this out time and time again (just look at Coca-Cola fifteen to twenty years ago; after years of plodding along, analysts finally realized the value of the firm and the stock price tripled within a three year period).The key is to ensure that you are not overpaying for your piece of the equity pie (see: Price is Paramount for more information). In Wal-Mart’s case, you may want to take solace in the fact that famed billionaire investor Warren Buffett has invested over $1 billion of Berkshire Hathaway’s capital in the retailer’s shares at a price slightly above the current market quotation. If the “Oracle of Omaha’s” analytical skills remain intact (a question very few people seriously doubt), then the risk of overpayment should be extraordinarily remote. In the meantime, perhaps you can take comfort in the ever-increasing cash dividends these blue chips keep generating for their owners, allowing you to focus on the business rather than the ticker. Better yet, take advantage of these prices through a disciplined dollar cost averaging program and in a few decades, your retirement is likely to thank you.
