Stock prices are driven by a company’s earnings and information that affects the prospects for a company’s future earnings. It is the most important factor when valuing a stock. I cannot stress this enough; Determining what price a stock should trade at depends entirely on a company’s earnings and its ability to maintain or increase its earnings in the future.
Background
Companies publish earnings reports quarterly, usually in January, April, July, and October. These reports provide essential information for valuing a stock’s price, and it is common to see large movements in a stock’s price immediately after an earnings release. Also at this time, most companies will provide forward-looking guidance indicating what the company expects to earn over the next quarter.
Several key statistics can be easily derived from a company’s earnings report, including a company’s net income and a company’s earnings per share.
Definitions
The earnings per share of a company is equal to the company’s net income over the total number of shares outstanding.
Earnings Per Share = (Net Income – Dividends on Preferred Stock) / (Average Shares Outstanding)
The P/E ratio (price-earnings ratio) commonly known as the multiple and is equal to the price of the shares over the annual earnings per share of the company.
P/E Ratio = Current Stock Price / Annual Earnings Per Share
By contrast, the FP/E ratio (forward price-to-earnings ratio) refers to the current stock price over a company’s forecast annual earnings per share for the next several years.
FP/E Ratio = Current Stock Price / Expected Annual Earnings Per Share
Classification
The PE ratio is a key metric, indicating how much investors are willing to pay for a company’s current earnings. At a basic level, the higher the PE ratio, the more expensive the stock will be. However, stocks are not traded based on their current earnings, but rather based on their predicted future earnings. In other words, the value of a company is not equal to what it earns today, but rather to what it earns tomorrow.
value stocks
Value stocks are simply stocks that trade at low PE indices. These stocks typically have much lower growth rates, meaning their earnings are expected to grow at a much slower rate, typically less than ten percent per year. It is important to note that value stocks have outperformed growth stocks in the last ten years. An example of a value stock is Exxon Mobil Corp, which is currently trading at 12.3 times earnings.
growth stocks
Growth stocks trade at high PE indices because they trade exclusively on future earnings and not current earnings. These are companies whose earnings are expected to grow substantially in the future. Investors are willing to pay more for companies that can generate higher returns in the future. Since growth stocks are largely geared toward future earnings, a growth company that reports lower-than-expected earnings can fall substantially on the news. One of Jim Cramer’s rules is to never buy a stock that is trading at more than double its growth rate. This means that if a company is only expected to grow by 10 percent and trades at a multiple of 20, then he considers the stock to be expensive. An example of a growth stock is Transoceans, which currently has a growth rate of 205 percent; however, Transoceans can also be considered a value stock as it is only trading at 10.8 times current earnings.
Stocks with accelerated income growth
Stocks whose future earnings are increasing, meaning the company’s earnings are expected to not only grow but continually grow faster, deserve a very high PE ratio. These are very risky stocks, but they can provide big returns if their growth rate continues to increase.
Conclusion
When valuing stocks, it’s important to remember not only current earnings, but also anticipated future earnings. We want to buy stocks that have low multiples compared to their projected future earnings. This means that we want to always keep an eye on stocks, which have future growth rates above their current multiples. It’s also important to keep up with the news, looking for things that might affect a company’s current or future earnings.
Disclaimer
It is not enough to buy a share in a company based solely on earnings. There are many factors that can affect the performance of a company. This is just one of many key metrics I use to value a company’s current share price.
