How Stock Prices Follow Earnings

More than 50 years ago, Benjamin Graham, the ‘Father of Value Investing’, observed, “In the short run the market is a voting machine, but in the long run, it is a weighing machine,” That one quote contains as much wisdom today as it did then and it’s implications have been long recognized by those we consider Investment Masters.

Stock Prices Earnings

What Graham was referring to were the two forces acting on securities, namely human psychology and business fundamentals. In the short run, human psychology can overwhelm fundamentals. However, over the long term it’s a securities earnings that determines returns.

Stocks are more than just pieces of paper. When you invest in stocks you are investing in the underlying businesses; management prowess, business culture, competitive advantages, re-investment opportunities and the like. The ultimate determinant of the price of the stock will be the underlying business’ performance. Buffett once again reiterated this in his 2017 annual letter.

Marketable Common Stocks

“Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well.”

The key to long term market beating results then is to identify quality businesses whose earnings will grow, buy them at a reasonable price and stick with them. It is the sticking with them where most investors come undone. Adopting the mindset of a business owner as opposed to a stock trader can help.

“Our business owner mentality.. allows us to virtually ignore the constant babble of short term macro noise.” Allan Mecham

“People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy. They are buying a piece of the business.. You are not buying a stock, you are buying part ownership in a business. You will do well if the business does well, if you didn’t pay a totally silly price. That is what it is all about.” Warren Buffett

Focus on Earnings Works

There are some good reasons a focus on earnings works. Firstly, share prices are volatile, and far more so than corporate profits. Share prices are influenced by the emotions of the crowd. And even more relevant today, they can be driven by the flows of indexing, ETF’s and momentum strategies.

“Securities prices rise and fall much more than profit … Why is that so? Primarily, I think, because of the dramatic ups and downs in investor psychology” Howard Marks

“When an S&P 500 ETF is purchased, its underlying securities are not bought for their individual value, earnings potential, financial health, or any other metric. Those securities are purchased simply because they are on the ETF’s shopping list. This process is without regard to the price/value relationship. As a result, serious distortions in price have accumulated.” Frank Martin

Consequently, short term share prices can do almost anything. The record amount of money in passive funds today, means you can and should, expect irrational prices. There is no price too high for an index fund to BUY and there is no price too low for an index fund to SELL. Prices get set by flow not fundamentals.

A Business’ Value is a Function of its Future Earnings

Secondly, a business’ value is a function of its future earnings, often estimated using a multiple of earnings approach.

“Business value is rooted in long-term earnings.” Allan Mecham

“Investors own a claim to the current and future profits of a company” Christopher Bloomstran

“Past profits only rewards past investors not today’s buyers. And it is future earnings that make up intrinsic value.” Francois Rochon

If you buy a business whose earnings are higher in the future, it’s likely the share price will be as well. Consider a simple example. You buy a $100 stock earning $10, ie an undemanding P/E of 10X. If its earnings grow at 12%pa, in ten years it will be earning almost $28. Providing the P/E’s unchanged, it will be trading at $280. If it is still trading at $100, the P/E would be just 3.6X, an unlikely scenario.

“There are only two things that matter in investing. What are they going to earn, and what multiple are people going to put on that. Let’s not make our business any more complicated than this” Larry Robbins

The good news for investors with a long term investment horizon is that in the long run, earnings and shares prices do converge.

“If the business does well, the stock eventually follows.” – Warren Buffett.

“Ultimately the market does reflect value, even if it may seem to lose its marbles for unbearably long periods” Leon Levy

“Stock prices often move in opposite directions from fundamentals but long term, the direction and sustainability of profits will prevail.” – Peter Lynch

“Over time, earnings determine a stock’s value.” – Joel Tillinghast

Market and Corporate Performance

“We believe that the market performance of a share of common stock, over an extended period of time, is likely to follow the business performance of the underlying company.” – Lou Simpson.