Skip to main content

Sound Advice: September 1, 2021

It’s 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

 203-222-9370

www.soundasset.com

www.soundasset.blogspot.com 

Any questions?  Please contact me at nrwayne@soundasset.com

Comments

Popular posts from this blog

Sound Advice: July 8, 2020

Jobs Are Up, But So Are New Infections Through the spring months, m ost of the economic data was extremely negative, with record declines in employment and consumer spending.  The speed of that decline had no modern precedent. We are now in a recession.   The shortest recession on record occurred in 1980 and lasted just six months.  Second place goes to a seven-month recession in 1918-19, which was tied to the Spanish flu pandemic.  The big question is: When will this recession end? Given surprisingly strong data in May, April may have been the bottom of this economic cycle.  If so, it will have been the shortest recession on record.  With massive support from the Federal Reserve, the federal government, and the reopening of previously closed businesses, employment surged unexpectedly.  At the same time, pent-up demand, stimulus checks, and generous unemployment benefits led to a reacceleration of commercial activity. Still, not all is rosy.   In his recent testimo

Sound Advice: May 17, 2023

Say hello to PEG No, she’s not a new neighbor.   PEG is the acronym for Price-to-Earnings Growth Ratio.   Although stock analysts tend to litter their conversations with shop talk such as PE (Price-Earnings Ratio), ROI (Return on Investment), and Debt-to-Equity Ratio, PEG may well be more telling about the level of stock valuations. The process of evaluating stocks begins with evaluations of the underlying companies.   This includes income statements (a.k.a., profit and loss statements) and balance sheets. Concerns about income statements focus on the trends in earnings, which include profit margins, tax rates, and net income.   What’s important here are the trends over time.   Are margins rising or at least holding their own? Are tax rates following a consistent pattern or have there been interim aberrations? And is the bottom line expanding? Flat or rising margins are good.   Level tax rates are also OK, but if there’s been an outlier, what would have been the impact on net i

Sound Advice: April 13, 2022

Tough Time For Bonds Over the years, difficult periods for the stock market have invariably prompted “flights to quality” on the part of investors.   In most cases, these shifts meant that funds were being moved from higher risk holdings to those appearing to offer increased safety.   That usually led to a redeployment from stocks to bonds, typically those of the U.S. Treasury or high-grade corporate borrowings.   With interest rates now rising, however, that approach is no longer working.  Indeed, in recent months it has backfired.  In the latest calendar quarter, the Treasury market posted its worst performance in more than 40 years.  For the period, the ICE 15+Year U.S. Treasury Index sustained a loss of 13%.  The iShares 20+ Year Treasury Bond Index dropped 14%. This is typical of what takes place when interest rates are rising.  The rule of thumb for bonds is that when rates rise, bond prices fall.  In most cases, the longer the maturity of the bonds, the greater the interim