Earnings Create Value

  • Earnings drive company valuation, which drives stock prices.
  • Various case studies demonstrate the trend between earnings and stock price.
  • Analyzing a company's past earnings and future earnings potential should be the starting point for securities analysis.

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 post, "What Drives Stock Prices?", explores a practical approach to understanding how earnings can move stock prices. This post demonstrates this occurrence in the stock market.

To begin solidifying the relationship between the earnings and a stock's price, take a look at the following graph.

Earnings Create Value fastgraph fdx xprice

The above graphs shows the historic adjusted earnings over the previous 20 years, as well as the next 3 years of forecasted earnings, of FedEx Corporation.

Across the bottom of the graph, we see the earnings per share, or EPS, the company has recorded (or will record) across the selected time period. These metrics are visualized on the graph with orange, blue, and white lines.

The orange line represents a fair value price-to-earnings (P/E) assessment of this stock. For companies growing EPS, less than 15% annually, a typical objective guideline is a P/E of 15. In this case, the average growth has been a bit higher, leading to the fair value benchmark P/E of 15.4. I will do a deeper dive into this topic in a future post. The area under the orange line is filled with a deep green color.

The blue line represents the P/E that the company has historically been valued at, known as the Normal P/E. 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 which are paid out by the company multiplied by the fair value P/E. This line gives a quick visualization of the payout ratio. The payout ratio is important to make sure the company has enough money to pay out the dividends, but also keeps some money to reinvest in the business. It is an important metric for analyzing the continuation, or safety, of a company's dividend policy.

As you can see, FedEx has, for the most part, had solid earning growth over the years. There were times when earnings struggled. The vertical grey bars indicate periods of recession. 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.

Earnings Create Value fastgraph fdx Graphs from fastgraphs.com

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, the fair-value guiding P/E of 15.4, would have been a formidable strategy. However one must be careful to not invest solely on the past. If the future earnings outlook is dim, the stock may not be a good investment even if the P/E drops below 15.

For another example, we'll next examine the adjusted earnings graph of The Boeing Company.

Earnings Create Value fastgraph ba xprice

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.

Earnings Create Value fastgraph ba

Adding the price to the graph, we can see how the stock's price has closely tracked earnings over time. Here, the investment strategy of simply buying when the price dips below the orange line would not have been as effective. The earnings, and price, may continue to drop for some time. Since Boeing has been able to bounce back and continue growing earnings, the price would have recovered on any dip. There may, however, have been better opportunities at the time of that investment.

Another important point, which is 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 begins to price it in. The market participants consider any news and it's impact on the company at the time the news is known.

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 and over valued tend to do so for a reason. To distinguish between an opportunity and a trap, further due diligence is required.

To better understand a company, there are many other factors that need consideration. 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 as we saw above.

I propose that these factors become critical in analysis due to the influence they can have on earnings. Whether directly or indirectly, these metrics helps 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.

In conclusion, understanding the importance of earnings is the first step for a long-term investor. Given the strong correlation between earnings and stock price over time, I suggest investors begin with analyzing the company's historic earnings and future earnings estimates. However, analyzing earnings alone is not sufficient. No single metric should be considered in a vacuum. All available facts should considered before deciding to invest in a company. With a stringent policy on earnings record, further investigation would only be conducted on the best opportunities available.

In the end, it comes down to making money.

In subsequent posts, I will work to build on this understanding, incorporating the rest of the fundamental metrics.

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