On Wednesday, we introduced Maxim Integrated Products (Nasdaq: MXIM), a company that has seen a bang-up appreciation in its share price over the past few years. We then attempted to get at the main driver behind this impressive performance, before our Foolish editors cut us short. (Blast those editors!)

What causes a company's share price to increase over time? Jeff and I have often cited rising earnings, margins, and returns as three numbers-oriented performance measures that we use as guideposts for projecting potentially higher stock prices down the road. But in the case of Maxim, none of these measures moved in a way that can come close to explaining the 57% compound annual rise in the firm's stock between 1996 and 1999. Margins held steady and return on equity actually declined. Consistently higher revenues resulted in earnings expanding at a 17% compound annual rate, but that was a much slower rate than the overall share price appreciation.

Given the firm's financial performance, why had the market decided by the end of last year that Maxim was now worth nearly five times what it was deemed to be worth just three years before?

As a preliminary conclusion, we posited that Maxim's stock rise can be explained by the market affording the company a higher price-to-earnings ratio or "multiple." This seems logical enough. If the "P" in the P/E rises faster than the "E," then the ratio will always spit out a higher number -- unless the rules of mathematics are repealed. (As an aside, quite a few observers have suggested that just such a thing is happening in some of sectors of the stock market today, but that's another can of worms entirely.)

There's more to this story, however. Here's a chart tracking Maxim's year-end trailing earnings and P/E from 1996 to 1999. As a comparison, the average year-end trailing P/E for the stocks in the S&P 500 Index has also been included.

                     1996   1997   1998   1999
EPS                 $0.87  $0.94  $1.18  $1.29 
Multiple            12.4x  18.3x  18.5x  36.6x 
S&P 500's Multiple    21x  24.5x    32x  32.5x

Looking at the chart, a couple of things immediately pop out. First of all, we can start to appreciate just how important multiple expansion has been to Maxim's overall share price rise. For example, if Maxim's multiple had stayed constant at 12.4x for all four years, the firm's share price at the end of 1999 would have been $15.99, not $47.21. From the starting share price of $10.78 at the end of 1996, that would have been a 48% total return instead of the 338% return that was actually realized.

The second point that we can take away from the chart above is that while Maxim's multiple started out below the average for the S&P 500, it eventually caught up as the years went by, surpassing the average P/E for the index by the end of 1999. This is the point we really want to emphasize. Maxim's share price didn't simply go up. More accurately, the multiple expanded from below-average to above-average.

There is no magic trick to predicting perfectly that multiple expansion will occur for a certain stock in the future. Basically, the best advice is to focus on companies with strong fundamental businesses, analyze them thoroughly, and become familiar with what their appropriate prices are on an earnings multiple basis relative to the market or, individually, relative to a peer group. The longer you follow an industry closely, the easier these "appropriate price" determinations will be. As I heard one investor put it recently, "Experience provides good guideposts and gives us a good sense that we're on the right track with our investments."

Jeff and I are aware that not every company on the planet deserves an above-average earnings multiple. But more often than not, we believe that the types of companies we consider for inclusion in this portfolio do deserve a higher-than-average multiple. This can be due to their leading market positions, well-defined competitive advantages, strong performance histories, high return business economics, and/or potential for earnings growth -- all of which are traits that we find in Maxim and we have repeatedly said we look for in Drip Port companies.

To sum up, our definition of "an ideal stock" is a company with the following traits:

  1. above-average business characteristics
  2. the potential for above-average earnings growth
  3. priced in the market at a below-average earnings multiple

Above-average businesses selling at below-average multiples can be pretty hard to come by. And given our long-term time horizon, we can probably accomplish our goals by investing our money each month in companies that only sport the first two of these three traits. However, the ideal long-term Drip investment would have all three.