Stock prices are supposed to be related to company fundamentals, but in reality there is only an indirect relationship between the two. If the relationship were direct, it would be a relatively simple task to calculate the fair market price for a stock, but fundamentals are merely a starting point for stock valuation, a starting point that is soon forgotten in the heat of the auction market. Let me demonstrate how investors quickly graduate from the hard facts in the financials to the smoke and mirrors of the investment industry. Let's begin with a review of basic fundamentals.

Book Value

The search for value starts with the basic accounting formula:

Assets = Liabilities + Equity

or

Assets - Liabilities = Equity

This formula is the basis of the company's balance sheet, wherein we subtract total liabilities from total assets to find a company's net worth, commonly called "book value". Another word for "equity" is "capital", so, when you hear reference to "capitalization", there is a thin thread of logic leading back to the equity section of the balance sheet.

Of course, book value is a static measure of value, and it only tells us what the net worth or the theoretical liquidation value of the company is at a given point in time. It tells us nothing about a company's ability to generate profits.

Earnings

Another accounting document is the "income" or "profit and loss" statement:

Revenue - Expenses = Net Income (Loss)

The income statement measures company performance over a specific period of time. We subtract expenses from revenues, and at the end of the annual accounting period the hoped for result is that the company has a net profit, which would result in the equity portion of the balance sheet getting larger. Wall Street usually refers to the profit or loss as "earnings".

Price to Earnings Ratio

When we divide the price per share of stock by the earnings per share, the result is the Price to Earnings Ratio or P/E Ratio. For example, if a company's stock is selling for $100 per share and annual earnings are $5 per share, we divide 100 by 5 and get a P/E of 20. The P/E is also referred to as a "multiple". In this case we would say that the stock is selling at a multiple of 20 times earnings.

Another way to think of P/E is that it represents the number of years it will take to get a 100% return on the investment. In the above example it would theoretically take 20 years to double our money. When evaluating P/E, we should keep in mind that it takes about 12 years to get a 100% return when investing money at 6%.

A Real World Example

Before we graduate to Wall Street, lets examine how all this would work in the real world. Let's say you wanted to buy a private company named Decision Point, a publisher of online financial materials, which is priced by the (greedy) owner at $60 million. Company assets consist of a popular web site and a few computers, and annual earnings are $2 million (don't I wish).

Based on this information the company has a P/E of 30 (60 divided by 2). Now, if you had $60 million in the bank, would you want to buy this company? A P/E of 30 is not too wild by Wall Street standards, but consider this: If you invested your $60 million at 6% interest compounded, you could get a 100% return on your investment in about 12 years. Does it really make any sense to buy this company when you can get a better rate of return at a much lower risk? Maybe it does, if you can visualize circumstances where you can increase earnings by five or ten times in a few years, but on the face of it you'd be better off with the money in a CD.

But let's say you buy the company anyway because you have a plan that will turn it into the next MegaBucks.com. As the new owner it is nice to know that you get to keep/spend/reinvest the $2 million of annual earnings the company generates. That is the nice thing about actually owning a private company in the real world -- you have control over it.

The Reality Disconnect

When you own stock in a publicly traded company, you don't have control of anything, unless maybe you're Warren Buffett; however, the investment industry sales machine continues to successfully pitch the idea that stock ownership is the same as owning the company. It's not. Unless the company pays a dividend, you do not participate directly in the earnings. Sure, we hope that earnings will rise, and that rising earnings will cause the price of the stock price to rise, but there is no guarantee that earnings will rise, or, if they do that the stock price will automatically rise because of it, because there is no direct relationship between earnings (or any other piece of fundamental information) and stock price. Period.

This is where most investors are disconnecting from reality, participating actively or passively in discussions of fundamentals of publicly traded companies as if they had the same concrete relevance as they would with a privately owned company. These discussions are usually  flights of fantasy commonly referred to as "the story". Here investors build a projection of future stock price on the quicksand of projected earnings, industry outlook, and wishful thinking all wrapped up in a respectable package called fundamental research. It is not research, it is speculation.

There is nothing wrong with speculation. As investors we have to speculate about the future, but it is essential that we know when we are crossing the line between fact and speculation (say fantasy). There are technical facts (the price trend) and fundamental facts (reported earnings), and from those facts we  must speculate about the future trend and earnings.

The following chart is a good example of the reality disconnect in action. Historically the stock market has maintained a normal P/E range of between about 10 and 20. A logical view of reality would say that, when prices move outside that normal range on the high side, there is an unacceptable level of risk; yet, in 1999 people were still able to assemble a convoluted fundamental logic to justify the extremely overvalued level of prices and to believe that prices would go substantially higher, even though there was clearly no fundamental justification for that happening.

It is important to understand that the reality disconnect helps create the illusion that the price paid for a stock is directly supported by the fundamentals at the time the stock is purchased -- that the fundamentals of the moment form a rock solid foundation upon which the stock price rests. The next step down the road to ruin is to conclude that improvements in the fundamental picture will result in proportional increases in the stock price. Conversely, the belief is that, if the fundamentals remain the same, the price will not drop below the purchase price. None of this is true, of course, as the following charts will illustrate.

The chart of Alcoa above shows that the stock price increased almost 90% between March and May, yet there was no change in the fundamental picture that would have justified such a radical increase in price.

On the chart of Time Warner (formerly AOL) above we see price almost doubling between March and April, then dropping nearly 50% between April and June. Did fundamentals change so radically twice in such a short period of time? Of course not.

These charts demonstrate the reality of the stock market: Stock prices move as a result of changing attitudes about the stock and, maybe, the company. At the most basic level people buy stocks because they think the price is going to go up, and they sell stocks because they think the price is going to go down. This thought process is carried out at a very basic emotional level and has nothing to do with fundamentals, although a fundamental rationale is often trotted to justify a purchase or sale.

If we want to operate in the realm of reality, we buy stocks when they are going up, and we sell them when they are going down, and the sooner we recognize the change in trend the better. And, where value is concerned, the best rule of thumb is that stocks are overvalued at a P/E of 20 and they are undervalued at a P/E of 10. All this phony baloney about it being okay for some industry groups or stocks to carry a higher P/E is nonsense. You wouldn't operate in the real world buying a private company on that basis, so that logic doesn't fly in the stock market. Sure, you can buy a stock with a P/E of 600, but don't kid yourself that it's a good idea fundamentally.

None of this means that you should move to a bomb shelter when P/E's get out of whack on the high side. When the market is moving up, you want to participate. A stock can drop 50% even if it has a P/E of 5, and another stock can triple with a P/E of 500. The stock market is a nutty, emotional organism. Just remember that and don't get sucked into the dangerous pseudo-logic of the reality disconnect. The market doesn't price stocks based on fundamentals, rather it prices stocks based on an emotional reaction to fundamentals.

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(The following was rewritten from an article in the 9/30/2000 issue of the Decision Point Alert.)

REALITY Vs. PEG

One of the most difficult things about analysis and decision-making is dealing with our tendency as humans to construct a rationale to support our actions regardless of the facts. Specifically, we filter out relevant, if not crucial information, so that we get to do what we want to do. Then, when what we did doesn't bring the result we had hoped for, we wonder why and, as often as not, blame somebody else for what was our own faulty rationalization.

This mechanism is frequently at work with our personal relationships. If association with person fulfills our needs for love, social status, money, etc., we will overlook evidence of serious character flaws. Sometimes we even marry these people. For example, I have been married for almost 40 years -- thanks primarily to the patience and determination of my wife to overcome my shortcomings, which she failed to acknowledge until it was too late.

I had a close friend for over 30 years. I watched him betray friends, wives, and business associates, but we remained friends because he was bright, charming, and relieved my insecurities by telling me how terrific I was. When it finally suited his purpose, he betrayed me. It took me over a year to come to terms with the fact that I had known what he was all along, but chose to ignore it.

To segue back to the subject of investing, every time I drag out that chart of the S&P 500 relative to its normal P/E range, I get some mail telling me that this valuation method no longer applies, that I should be more open-minded and up-to-date in my thinking. Projected Earnings Growth (PEG) is now the appropriate way to value a stock. Why is PEG now "the thing"? Because it gives us a seemingly rational justification to do what we want to do. Long-term investors do, after all, need some reason to buy a stock with a P/E of 200.

The flaw in the PEG rationale is that nothing goes on forever, and PEG only works with high P/E stocks when there is a glut of money in the market that pushes stocks out of normal valuation ranges. You can't draw a straight, up trending line into the future and consider that it will never be broken. As technicians, we draw trend lines, but we EXPECT that they will eventually be violated; however, the majority of investors are not technicians, nor are they critically analytical about their investment decisions. They listen to and trust the investment industry sales machine, which tells them not to worry, the stock market always goes up. This is what they want to hear. Someday they will look at their bombed-out portfolios and ask, "What about PEG?" The answer will be, "It was a lie."

Shifting one's investment approach to fit current conditions is sensible and is best accomplished by following price trends. As technicians we can do that without much heartburn about how stocks are being valued by fundamental analysts, but I still look to the normal P/E range as a guide to how well prices are being supported by fundamentals. In my opinion, the fact that prices are far beyond the normal range set by traditional valuation methods is not the announcement of a "new paradigm" for long-term investing, it is a red flag that risk is high and a warning of serious trouble ahead.

While we technicians use different (and I think better) analysis tools, we are also vulnerable to (and guilty of) filtering out evidence that does not support what we want to do. Technical indicators are never unanimous in their message, so part of our task is to ignore those that are not telling the truth. Unfortunately, it is at this point that we are vulnerable to losing our objectivity, and may choose to believe the wrong indicators in order to support the scenario we prefer. The way to protect ourselves from this is to use a disciplined system to enter and exit positions. Just as we use a stop loss to exit, we have a set of rules we use to open a position. Replace denial with discipline.

--Carl Swenlin