All About The Earnings
For stocks, the key driving force is EPS, earnings per share. EPS is the same thing as profit or net income per share. Over time, when a company’s earnings are rising, its stock will follow. The two are not always in lockstep, but most assuredly they will move in the same direction.
There are nuances that impact current stock movements and probable price action ahead. Among the most important is the price-earnings ratio. It’s also known on Wall Street as the P/E, the price-earnings multiple, the multiple, the valuation rate, and the capitalization rate.
The P/E is derived from a simple calculation. The P stands for the price of one share of stock. The E stands for earnings per share, which is the company’s net income divided by the number of shares outstanding. EPS and P/E information is available on many financial websites including Yahoo! Finance and MarketWatch.
By itself, the P/E is not helpful. What’s missing is the historical range of P/Es for the company’s stock and well as the prospective growth rate of that company. Typically, the higher the growth rate, the higher the P/E.
The relation between the P/E and the growth rate is put in perspective by the PEG ratio, which is derived by a simple calculation: P/E divided by the company’s prospective growth rate. So if the P/E is 20 and the growth rate is 10% a year, the PEG is 2.0.
PEG ratios tend to vary widely. In rare cases, there are PEG ratios below 1.0, but those are usually cyclical companies whose results tend to follow boom and bust cycles. The other extreme is high growth companies for which investors often ignore reality and expect the best possible outcome.
A productive investment approach is to seek stocks with PEG ratios toward the lower end of the scale, topping out at no more than 2.0 to 2.5. During periods of market strength, this will require considerable diligence, but when the stock averages are slumping, better values will be widely available.
There’s more. Although there’s an extraordinary amount of investment information at one’s fingertips today, that wasn’t always the case. Before the introduction of the Apple II and IBM PC computers, companies were far more close-mouthed about how their operations were going. Fast forward to today, the pendulum has swung far in the direction of transparency. Many companies now provide ongoing guidance about their pace of business and the impact on their earnings.
Not surprisingly, there’s a wrinkle here. In addition to the earnings guidance provided by company management, there’s also something known as the whisper number. That’s the number bandied about by Wall Streeters, which may or may not be the same as the target the company is shooting for.
If the earnings guidance number and whisper number are the same and the company’s actual earnings (and sales) are in line with those numbers, there’s unlikely to be a major impact on the stock. But if there’s a shortfall below the whisper number (when it’s higher than the guidance), the stock may plunge.
All of which points back to the same thing: Over time, stock prices are driven by changes in underlying earnings. During shorter periods, however, investor psychology rules the day.
N. Russell Wayne, CFP®
Sound Asset Management Inc.
Weston, CT 06883
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