Since smart investors are always looking to invest in the best businesses, they will attract the most investor attention.  However, there is an often overlooked danger associated with focusing on business results alone. Great business results can attract undue and excessive capital which can inflate valuations beyond what business and economic realities would justify. When this happens, investment returns of even the best businesses can become distorted and devalued.  Investors need to be aware of, and acknowledge, that the current market price is not necessarily the correct price.  Knowing that the market can behave irrationally, and recognizing when it does, either over or under, is a great investor benefit and advantage.

From 1996 through 1999, the period infamously dubbed "irrationally exuberant," Wal-Mart's stock price clearly became excessively overvalued. Consequently, even though operating results (earnings growth) continued on its superb and consistent trajectory, stock price had nowhere to go but sideways or down.  It appears that investors infatuated with Wal-Mart's continued success were blinded to the poor economics created by such lofty valuation.  Apparently, because the news continued to be so positive each quarter, investors continued to hold their overvalued positions. However, it would also appear that prospective new investors were thwarted by the huge premium they had to pay to buy Wal-Mart shares.  Of course, these last statements are based on the assumptions presented, and they seem to be the only logical conclusions that can be drawn from reviewing the facts.

Overvaluation's Terrible Toll On Shareholder Returns

Regardless of whether our assumptions stated above are correct or not, the mathematics underneath Wal-Mart's share price based on its earnings justified valuations made no economic sense from late 1997 on.  The PE ratio on Wal-Mart shares by year-end 1999 was over 55 times earnings, which calculated out to an earnings yield of only 1.9%. From the time this began in 1997 to its peak in late 1999, was a time frame when Wal-Mart Stores could only be considered a speculative momentum play.  In other words, owning shares in Wal-Mart Stores at these inflated valuation levels was not a sound investment, even though the business continued its strong and consistent rate of earnings growth averaging over 10.5% per annum from 1996 to 1999.

The following earnings and price correlated graph shows what happened after Wal-Mart became excessively overvalued by late 1999. When you examine Wal-Mart Stores' subsequent price behavior in relation to its operating earnings, the dangers of overvaluation become visually crystallized.  Since there was no true economic value supporting the stock price, it had nowhere to go but down in the long run until it eventually became aligned with its earnings justified value by late August to early September of calendar year 2007 (see first orange arrow).

It's interesting to notice that once it touched its intrinsic value (the orange line), the stock appreciated approximately 35%, from approximately $44 per share to approximately $59 per share over the next 12 months (red arrow on graph below).  However, this time it didn't take almost 8 years for the overvaluation to correct itself.