Earnings Create Value
A company’s intrinsic value has a direct relationship to the company’s earnings or earnings potential. As earnings fluctuate, so will the company’s value.
A company’s intrinsic value has a direct relationship to the company’s earnings or earnings potential. As earnings fluctuate, so will the company’s value.
The story What Drives Stock Prices? explores a practical approach to understanding how earnings can move stock prices. This story demonstrates this occurrence in the stock market.
FedEx
To begin solidifying the relationship between the earnings and a stock’s price, take a look at the following graph.
The above graph shows the historic adjusted earnings over the previous 20 years, as well as the next 3 years of forecasted earnings, of FedEx Corporation.
This graph represents the company’s annual earnings per share, or EPS, which are listed below the x-axis. These earnings are visualized on the graph with orange, blue, and white lines.
The orange line represents a fair value price-to-earnings (P/E) benchmark. Each point on the orange line is the product of the corresponding annual EPS and the P/E of 15.4.
For companies growing EPS less than 15% annually, a typical guideline is a P/E of 15. In this case of faster growth, the benchmark P/E should be higher. A good rule of thumb is to set the P/E multiple equal to the growth rate. In this case, the growth rate is 15.4, leading to the fair value benchmark P/E of 15.4.
The blue line represents the Normal P/E, or the multiple the company has historically traded at. Each point on the blue line is the product of the corresponding annual EPS and the Normal P/E of 18.7.
In the case of FedEx, we see the Normal P/E of 18.7 is greater than the fair value P/E of 15.4. This shows a tendency of the market to price FedEx at a premium — perhaps a result of strong management, strong industry potential, or any other myriad of reasons.
The white line represents the dividends paid out by the company multiplied by the fair value P/E. Considering the dark-green shaded area is the area under the orange line, the white line gives a quick visualization of what percent of the earnings are being paid out. Known as the payout ratio, it is an important indicator to ensure the company has enough money to pay dividends, and also gives an indication of what may be left to reinvest in the business. It is an important metric for analyzing the continuation, or safety, of a company’s dividend policy.
The vertical grey bars indicate periods of recession.
As you can see, FedEx has, for the most part, had solid earnings growth over the years. There were times when earnings struggled. Being a transportation company, FedEx was materially impacted by the Great Recession. Although the business faced declining earnings, FedEx was able to maintain profitability.
Now take a look at the following graph. Price, represented by the black line, is overlaid on the earnings graph.
The correlation between price and earnings is undeniable in this graph. The black line tracks between the orange and blue lines almost perfectly. There are periods of time when price deviates from earnings. Purchasing stock when the price dropped below the orange line seems to have been a formidable strategy.
Boeing
For another example, see the Boeing’s adjusted earnings graph below.
Here we see much more volatility in earnings. This is due to the cyclical nature of the industry. The future earning projections provide a positive outlook.
Adding the price to the graph, we can see how the stock’s price has closely tracked earnings over time. Notice that a drop in earnings — and price — may continue for some time.
Since Boeing has been able to bounce back and continue growing earnings, the price has recovered from any dip. This is not necessarily always the case. It is not guaranteed that companies continue to grow. Some companies with declining earnings may never bounce back.
An important point, made very clear in Boeing’s earnings graph, is the forward-looking nature of the market. As soon as the drop — or recovery — is in sight, the market prices it in. The market participants consider any news and its impact on the company at the time the news is known.
Fundamentals
The above examples make evident the tight correlation between price and earnings over time. There may be times when the price and earnings diverge. This could signal an opportunity and should lead to further investigation. Stocks that become under- or over-valued tend to do so for a reason. To distinguish between an opportunity and a trap, further due diligence is required.
There are many other factors to consider in order to better understand a company. Fundamentals metrics include not only earnings, but also revenue, debt, cash, growth prospects, management team, industry or sector, competitive advantage, cash flow, capital expenses, litigation and much more. These explain why different companies may have different valuation premiums or discounts, the difference between the fair value P/E and normal P/E.
These factors are critical in any analysis due to the influence they can have on earnings. Whether directly or indirectly, these metrics help calculate or predict earning potential. Considering all of the available facts and metrics will allow for a more accurate estimation of the company’s true value.
Earnings create value
Understanding the importance of earnings — and the role they play in valuations — is critical for a long-term investor. Given the strong correlation between earnings and stock price over time, I suggest investors begin their due diligence with an analysis of the company’s historic earnings and future earnings estimates.
Analyzing earnings alone is not sufficient. No single metric should be considered in a vacuum. All available facts should be considered before deciding to invest in a company. Further investigation—for example on the quality of the earnings, balance sheet, cash flows, the management team, the company’s culture, and the future potential, amongst many more factors — would be necessary to further distinguish high-quality investment opportunities.