Stock prices are driven by a company’s earnings and the information impacting the prospects of a company’s future earnings. It is the single most important factor when valuing a stock. I cannot stress this enough; determining what a stock should be trading at is completely dependent on a company’s earnings and its ability to sustain or increase its earnings in the future.
Companies release earnings reports on a quarterly basis typically in January, April, July, and October. These reports provide essential information for valuing the price of a stock, and it is common to see major movements in a stock’s price immediately following an earnings release. Also at this time most companies will provide forward guidance indicating what the company expects to earn during 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.
A company’s earnings per share 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 Outstanding Shares)
The P/E ratio (price-to-earnings ratio) commonly referred to as the multiple and is equal to the stock price over the company’s annual earnings per share.
P/E Ratio = Current Stock Price / Annual Earnings Per Share
Conversely, the F P/E ratio (forward price-to-earnings ratio) refers to the current stock price over a company’s forecasted next years annual earnings per share
F P/E Ratio = Current Stock Price / Forecasted Annual Earnings Per Share
The PE ratio is a key metric, which indicates how much investors are willing to pay for a company’s current earnings. At a basic level the higher the PE ratio is the more expensive the stock is. However, stocks are not traded based on their current earnings, but based on their forecasted future earnings. In other words, a company’s worth is not equal to what it is making today, but what it is making tomorrow.
Value stocks are simply stocks traded at low PE ratios. These stocks typically have much lower growth rates meaning that their earnings are expected to increase at a much slower rate, typically less then ten percent annually. It is important to note that value stocks have outperformed growth stocks over the last ten years. One example of a value stock is Exxon Mobil Corp, which currently trades at 12.3 times earnings.
Growth stocks trade at high PE ratios because they are trading entirely on future earnings and not on current earnings. These are companies whose earnings are expected to grow substantially in the future. Investors are willing to pay more for companies who can generate higher returns in the future. As growth stocks are very much driven towards future earnings, a growth company who reports lower then expected earnings may drop substantially on the news. One of Jim Cramer’s rules is to never buy a stock which trades above twice its growth rate. This means that if a company is only expected to grow at 10 percent and is trading at a multiple of 20 then he considers the stock expensive. One example of a growth stock is Transoceans who currently has a 205 percent growth rate; however, Transoceans may also be considered a value stock as it only trades at 10.8 times current earnings.
Stocks with Accelerated Revenue Growth
Stocks whose future earnings are increasing, meaning the company’s earnings are expected to not only grow but to continually grow faster, deserve a very high PE ratio. These are very risky stocks, but can provide huge returns if their growth rate continues to increase.
When valuing stocks it is important to remember not only current earnings but future forecasted earnings. We want to acquire stocks that have low multiples compared to their future projected earnings. This means we want to always be on the look out for stocks, which have forward growth rates above their current multiples. Also it is important to keep up with the news, looking for things that may impact a company’s current or future earnings.
It is not enough to acquire a stock in a company based solely on earnings. There are many factors that may impact a company’s performance. This is just one of the many key metrics I use to value a company’s current stock price.