Finding Value In The Stock Market

There is something of a great irony of the stock market. The impression of many average Americans is that the financial markets are very complex and mysterious mechanisms. Many are intimidated by the media images of the masters of the universe straddling Wall Street and the world markets.

There is some truth to the perception of complexity. The computer age has allowed the stock market to become heavily dependent on very sophisticated technology and software. Some of the brightest people from the best universities commit their intellectual skills to the game of beating the market averages and stock index.

For all that, however, there are extremely simple concepts and numbers behind the curtain at the Oz of Wall Street.

Every generation of investors has the privilege to participate in at least one market crash. There are lessons learned and then forgotten from these crashes. For this generation, the dot.com bust provides an excellent tutorial on the subject of profits. All crashes are, finally, about profits.

The most essential rule of Capitalism was set forth by Adam Smith in 1776. Smith explained a concept he termed the Invisible Hand. In short, he demonstrated that profit is a survival criterion for any business. Profits provide the essential return on invested capital. Without profits, capital is consumed and companies fail. Many dot.com companies were given tens of millions of dollars in capital. Their young executives dismissed the concept of earnings and profits. They wanted to go boldly where no man had gone. So much for the validity of that attitude.

One major weakness of the stock market is that investors love to follow fads. Even if they pretend to care about long-term earnings, they will follow a hot trend based on a new industry or a couple of hot companies. That results in stock prices that, for a short time, have no realistic relationship to true earnings. When this happens the assessment is that the price/earnings ratio, the P/E, is out of whack.

This is another place the stock market gets real simple. Over the past 50 years, the stock index for the 500 largest companies shows an average P/E of just over 16%. There is no reason to believe that average will change much in the coming years.

This number provides one very good metric for long-term stock market investors. If the current index is over the 16% average (it hit 30 during the dot.com mania), the market is probably overvalued. Conversely, an average index below that number might indicate there is value to be found.

Whatever the case, it is the profitable companies that will survive and create the best long-term investments.