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Sound Advice: March 1, 2023

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

www.soundasset.com

 

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

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