Market Value Tracks Return on Invested Capital and Growth
Over the past 15 years, investing in the stock market has been a roller-coaster ride. In the second half of the 1990s, the Standard & Poor’s (S&P) 500 index more than tripled in value to an all-time high of almost 1,500. Previous unknowns, such as Amazon and America Online (AOL), became stock market superstars along with a galaxy of other new economy and dot-com entrants. Then the market crashed, and many lesser stars flickered out. After 2003, stocks recovered at a stunning pace, and by 2007, the S&P 500 had regained its all-time high. However, the market crashed again in 2008 as a result of the credit crisis, losing around 50 percent of its value in the course of a few months.
People are questioning whether long-held valuation theories can explain such dramatic swings in share prices. Some even assert that stock markets lead lives of their own, detached from the realities of economic growth and business profitability. But have market values and the discounted cash flow (DCF) valuations described in Chapter 6 really separated? Does it make sense to view the stock market as an arena where emotions rule supreme?
We think not. Certainly, prices for some stocks in some sectors can be driven in the short term by irrational behavior, as we discuss in Chapter 17. For shorter periods of time, the market as a whole can lose touch with fundamental laws grounded in economic growth and returns on investment. And clearly not all ...