How well earnings can predict future stock prices

  • Post category:The Principles
  • Reading time:17 mins read

Peter Lynch dedicated an entire chapter “Earnings Earnings Earnings” in his book “One up on wall street.” Charlie Munger and Warren Buffett always talk about cash flows. I learned a great deal from their wisdom, but the impact of earnings wasn’t clear to me at first. I have witnessed wild stock fluctuations around earning dates. 10-15% swings are common. 50% isn’t a far-fetched idea either. Blockbuster quarterly earnings and positive wall street sentiment are enough for a stock to double in a couple of hours. But if we can get super results just by guessing & choosing the hottest stocks, why bother investing for the long term and average returns?

Ultra high growth stocks carry high expectations, and Investors want to earn more profit in less time, and these stocks are means to satisfy just that. As Warren Buffet correctly puts it, “No one want to get rich slowly.” The problem with stocks is that they may react to every news, positive or negative, which leads to wild stock price swings. I aim not to profit from these wild swings. I have no intention of beating the market or doing better than anyone else. As I stated earlier in my previous article, I aim to earn 12% over the very long term. So I have decided to concentrate on the actual business and measure business growth rather than the stock price. Guru of Investing Ben Graham said Mr. Market could quote absurdly high or low prices for business based on his mood swings. We need to wait when he is feeling down and gloomy.

One way to concentrate on business growth is through earnings. But an earnings beat or miss should not matter. Because I learned that analyst targets are one of many bogus things on Wall Street, they are seldom correct. Based on their estimates, you can create your own story (investment thesis), but investing based on their estimates alone is a recipe for disaster.

Concentrating on business growth rather than stock price helps in many ways.

  • It helps me avoid costly mistakes of acting based on every news. I measure success with my standards. The decision to hold, buy or sell solely depends on how business is doing.
  • Business growth is predictable when compared to prices.
  • Business doesn’t change overnight.¬†
  • I don’t feel an urge to check stock prices every day. In his book “Fooled By Randomness,” Nassim Taleb explained the probability of success of 15% gain with 10% volatility goes down from 93% to 50% when the time scale is decreased from 1 year to 1 day. So mathematically, not checking stock prices every day helps us in increasing our success odds.

But the big question remains, How well can earnings predict future returns? Let me backtest it with a couple of businesses. My hypothesis is the stock price follows earnings growth over the long term. At a minimum, if we have a 1:1 relation between stock price and earnings growth, then technically, it should be easy for me to predict future stock price provided the business keeps growing at the assumed rate. But Again, Calculating future growth isn’t precisely children’s play, But it is still better than predicting stock prices.

Price Increase Vs Earnings Growth

I chose the first 15 stocks that came to mind & tried little to diversify. It is in no sense a right sort of vetted securities that can help me conclude about the market as a whole. But these are the businesses which I may like to own. I didn’t include stocks that were not profitable. I might have overlooked some obvious stock choices, i.e., Apple. As no consequential recession happened during the last ten years, I might be doing this exercise in the wrong timeline. Selections may be flawed, but I aim to learn and understand how stock prices move with earnings.

Column K is multiples by which the price increased in the last ten years. Column N corresponds to multiples by which EPS increased during the same period. Column Q is simply the ratio of Price increase vs. EPS increase. A ratio of 1 will imply the price of the stock is directly proportional to earnings. I can deduce N number of things from this column, but here is a couple of them.

  • All stocks have ratios of one or more except FB & VZ. It’s the first proof that stock prices follow earnings.
  • Both of these stocks were trading at Premium PE of above 40 when market PE was around 15.
  • FB & VZ’s future earnings were baked into the price at that time. Both of them had to grow profits faster in the long term to justify. So in the long term, the stock price rose slower than earnings and hence a ratio of less than 1.¬†
  • If I invest in High PE stock, Then my margin of error decreases as I need to be sure that the business can earn exponentially more in the future.
  • Earnings of IBM, GE & XOM decreased 50% or more, and the same is reflected in their stock price except for XOM. (I took data for XOM before Covid as currently, it’s making losses). XOM seems to be an anomaly, but again I am concentrating only on earnings. They might very well have increased their dividends during this time.
  • Ratio’s for DPZ, AVGO, NVDA & AMD are well all over 2. Fortunes were made with these stocks as stock prices increased exponentially relative to earnings. PE of all these stocks was around the market average ten years ago except for NVDA. So investors didn’t pay the premium and, in turn, earned more relative to earnings. For NVDA, Current PE is still high, and hence compensates the premium paid by investors earlier.

Today’s High PE’s were not standard ten years back. The market was trading at 15 times the earnings. I would have called myself crazy If I had evaluated a business assuming terminal PE would be around 30. Given that I had no idea about future PE and keeping it at 15 and taking actual earnings, I calculated column R. It’s an adjusted current security price at 15 PE and the same earnings. Column S is adjusted price increase multiple. Anything above 3.107 would have achieved my goal of 12% per year CAGR. IBM, GE, XOM & VZ are the only companies below my cut-off & the reason is apparent. INTC is one company that benefits from using 15 PE as its current PE is well below 15. Most of the stocks on the list are well above 5. That means that I could very well be 50% off from my assumed earning growth rate and still achieve the goal of 12%. 

It was a very fruitful exercise as it helped me understand the impact of earnings on the future stock price. It also helped me comprehend that I can still make it if my assumptions are vague and off by 50%. It correlated PE with future returns. It may be wise to invest in average PE stocks. I will take this learning and apply it in future stock analysis. Stay tuned. Until then, Chao.