We all dream of discovering the next hot stock before the rest of the investing world finds out about it. All too often, though, you'll only find out about stocks with great potential after they've already gotten a lot of attention -- and after their share prices have enjoyed a terrific run. While that doesn't always mean it's too late to buy, it does mean you need to look more closely, to make sure any future success will find its way into the price of your shares.

Understanding the fundamentals
One of the fundamental axioms of investing is that the value of a stock comes largely from the earnings it produces. That largely explains why stock prices generally rise over time. Steady growth in a company's earnings leads investors to value shares more highly from year to year, as companies either reinvest those earnings into their businesses, make strategic acquisitions of other companies, or return money to their shareholders through dividends or share repurchases.

Even though the connection between a company's earnings and its share price tends to assert itself in the long run, there can be wide disparities over shorter periods of time. Especially with young, promising stocks, it's not uncommon at all to see shares get way ahead of the fundamentals. When some of those stocks fail to live up to all of the expectations that investors have, it can spell disaster for the shares -- even if the company eventually manages to see substantial earnings growth down the road.

Looking back
For some examples, think back to 2000. At that time, the Internet was in its infancy, and companies were only starting to figure out the full potential of new technology and the implications it had on the business world. Hundreds of companies with absolutely no history of generating earnings were getting unprecedented investor interest. And even outside the pure technology sector, you could find a typical mix of other companies that were just getting started, but which had amazing futures ahead of them -- and whose share prices fully reflected that enthusiasm in their high valuations.

Fast-forward to the present, and you'll recognize many of their names. What may surprise you, though, is just how little their stock returns resemble the great success that many of these companies have enjoyed over the past decade:

Stock

Current P/E

P/E in 2000

Annual EPS Growth Since 2000

10-Year Annualized Return

Biogen Idec (Nasdaq: BIIB)

17.1

114.8

27.9%

1.3%

SanDisk (Nasdaq: SNDK)

18.1

283.4

23.5%

(5.1%)

Amgen (Nasdaq: AMGN)

12.6

60.4

16.1%

(1.5%)

Best Buy (NYSE: BBY)

13.9

61.0

15.7%

3.8%

DuPont (NYSE: DD)

17.7

278.1

26.0%

(0.3%)

Coca-Cola (NYSE: KO)

18.2

48.0

11.6%

3.0%

Microsoft (Nasdaq: MSFT)

15.7

67.3

8.7%

(3.1%)

Source: Capital IQ, a division of Standard and Poor's. 2000 P/E ratios as of Mar. 31, 2000, and growth figures are measured from that date. P/E ratios are based on diluted figures excluding extraordinary items. Returns as of Mar. 3.

There's a lot of data in that chart, but basically it boils down to this:

  • If you looked at those stocks 10 years ago, they all appeared to have some promising growth years ahead of them.
  • They were also priced for absolute perfection, sometimes with ridiculous premium valuations -- even for stocks with a fair amount of earnings history behind them.
  • After 10 years, these stocks did generate impressive earnings growth.
  • But because investors paid way too much for the shares, they didn't enjoy good stock returns from that growth. In several cases, investors actually lost money, as P/E ratios contracted more than earnings grew.

It's not different this time
Often, when investors are trying to justify why a particular stock deserves a sky-high valuation, they'll try to argue that their stock is a special case. However, the math doesn't lie. If you pay too much for the prospect of future earnings growth, you're sabotaging your investing returns. Even if those earnings pan out, you've put yourself in an impossible situation in which the shares can't keep up with unrealistic expectations.

Some up-and-coming stocks actually give their investors great value. Let Ilan Moscovitz point you in the direction of three bargain stocks for this market.

Fool contributor Dan Caplinger refuses to pay too much for anything, just on principle. He doesn't own shares of the companies mentioned in this article. Best Buy, Coca-Cola, and Microsoft are Motley Fool Inside Value picks. Coca-Cola is a Motley Fool Income Investor recommendation. The Fool owns shares of Best Buy, which is also a Motley Fool Stock Advisor recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy tried scalping tickets once, but it couldn't take the heat.