Underlying Earnings are the Engines That Power
Stocks
With all due respect to ongoing rumors about mergers
in the works and remarkable new products such as cell phones that will dramatically change the
world, much of this is nothing more than talk of little value. The key is a phrase voiced by John Houseman
in a Smith Barney commercial back in the 1980s: “They make money the old-fashioned
way. They earn it.”
Experienced advisors know that the best approach to
successful investing is the ability to identify companies with sustainable
above average growth run by seasoned management that consistently plans well
for what it sees ahead. Extraordinary breakthroughs
are rare, but steady improvements of goods produced or services provided are
not. Those that lead in their respective
industries set the standards and are often among those favored on Wall Street.
You don’t need to be deeply engrossed in the
machinations of analysis to understand how the process works. But some familiarity with basic concepts is
helpful. It’s really about simple things
such as earnings per share, price-earnings multiples, earnings growth rates,
and debt-equity ratios. All of this information is readily found on well-known
financial websites such as Yahoo Finance and MSN Money.
Earnings per share is calculated by dividing the
company’s net income by the number of shares outstanding. The price-earnings multiple is calculated by
dividing the price of the stock by its earnings per share. So if the stock’s price is 30 and earnings
per share are $2.00, the price-earnings multiple is 15 times.
It’s best to view the pattern of earnings over a
period of at least three to five years.
The ideal pattern would be steady year-to-year gains. If, for example, the annual rate of earnings
growth would be 10%, a reasonable price-earnings ratio would be in the range of
10 to 20 times. If the growth rate is
higher, the price-earnings ratio would also be higher. But on more than a few occasions the
price-earnings ratio is stretched well beyond, which suggests that there’s a
considerable risk of erosion in the event of an earnings disappointment.
None of this needs to be calculated by an armchair
investor since all the data needed can be accessed with a few keystrokes. What you will find for estimates will
typically be what’s known as the Wall Street consensus, since analysts tend to
keep their numbers close to the average rather than coming up with outliers, which
if grossly inaccurate would cost them their jobs.
As folks might suspect, there are some exceptions to
the Wall Street consensus, typically for companies where there is greater likelihood
of surprise or disappointment. These
exceptions are known as the whisper numbers.
So even if companies provide guidance on the earnings they expect, some
analysts take the prognostication to a higher level. The hitch is that if a company’s earnings
match the guidance, but fall short of the whisper number, the stock may take a
hit.
N. Russell Wayne, CFPÒ
Any questions? Please contact me at nrwayne@soundasset.com
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