Earnings vs Stock Prices

“Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money.” Peter Lynch

“If you can follow only one bit of data, follow the earnings—assuming the company in question has earnings. I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction.” Peter Lynch

I read an article in Mortley Fools sometime back (read here). In the article, it mentions that “Gains in a stock’s price may have a more sustainable backing if it’s powered mostly by growth in its underlying earnings instead of having the market bid the price higher.” Consequently, in the article, a comparison was made between the percentage difference in share price, trailing EPS and trailing P/E ratio.

“Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.” Peter Lynch

“People may bet on the hourly wiggles in the market, but it’s the earnings that waggle the wiggles, long term.” Peter Lynch

This prompted to think about my own portfolio of stocks. True, in the very long term, stock price should correspond to increase or decrease in earnings.

Well, I have done a table below. The start date of each stock is roughly when I first started buying the stock. Some stocks are recent buys, hence there is very little correlation between the stock prices and earnings. I did not include some stocks which I have only recently bought, such as Sarine Technologies and ISOTeam as I don’t see much change in earnings.

Upon looking at the table, these are my thoughts:

• Basically there is really very little correlation between changes in earnings and changes in share prices. These past few years, we have been in an overall up market. So I reckon it explains the overall incremental buffer in share price changes (as compared to changes in earnings) . Eg. increase in share prices is more than increase in earnings. Also even if there is a decrease in earnings, the decrease in share price is less acute.
• In general, it is mainly an expansion of the price-to-earnings (PE) multiple that had propelled the stock prices to their current heights.
• I noticed some of the poorer performing companies have very high P/E, which is a cause of worry. Eg. Golden Agri, Singapore Airlines and SMRT. On the other hand, high flyers like Riverstone also has high P/E.
• A number of these poor performing stocks are cyclical stocks (eg. Golden Agri, SIA & CapitaLand). The correlation between earnings and P/E, and stock prices is not that linear. In fact, a better indicator would be using the price to book ratio. Some may even argue that when there is a high P/E, it is a good time to buy.
• The time span may not be long enough. Perhaps a 10 year gap would show more correlation between earning changes and stock prices changes.
• Perhaps now is really not the time to be buying stocks. It is worth observing the companies performance and perhaps sell over-valued stocks.

“Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.” Warren Buffett

Like what the Motley Fools article mentioned:

One, truly great returns come from patiently holding the shares of great companies. Like The Motley Fool’s co-founder David Gardner once wrote, “Find good companies and hold those positions tenaciously over time to yield multiples upon multiples of your original investment.”

I do not intend to immediately sell my stocks. I set up this table because of my curiosity, and yes, earnings do indeed impact stock prices.

As observed, the percentage changes in stock prices is much higher than that of earnings changes, probably because we are in a generally sanguine market (ok, perhaps not in China or Greece).  In the short term, emotion, rather than logic, plays a more important role in evaluating risk and making decisions in the stock market.

“Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.” Peter Lynch