HUMMONEY - Fact and Fiction (Perspective)

- by Greg Lewin

Simply put the price of a stock is a function of the current earnings multiplied by a ratio which supposedly captures investor expectations of future earnings called the P/E. Although simple, the number of variables that go into making these 2 calculations are enormous. What I would like to do in this article is challenge your perspective on the impact earnings and P/E have on stock price and therefore the relative energy and effort you may invest in gauging their ultimate outcomes.

The calculation of earnings for a company is a very well understood science. The 2 core variables which must be judged and analyzed are revenues and expenses, the analysis of which demands an evaluation of historical patterns, product cycles, product pricing, demand, input costs, financing, etc. Lots of detail work is necessary. However, public companies provide quarterly reports in which patterns and trends can be analyzed, in addition to commentary and forecasts provided by the company’s management team. Now if you consider that the vast majority of companies don’t grow very fast what you find is that Wall Street and its legions of analysts end up debating variances that often times amount to nothing more than pennies. But I assure you this is the element of stock investing where the majority of energy and effort is expended.

Let’s now contrast this with the impact of the P/E. Let’s start out with a simple example. If a company is capable of generating $1.00 of earnings and the stock market chooses to assign a 10 P/E to those earnings the company would trade at $10. If this multiple should rise to 12 or 15 the stock would then rise an additional 20-50%. If you realize that an average company’s earnings grow at less than 10% per year, merely changing the multiplier could account for, in this case, 2 to 5 years of earnings growth. Now if you consider that stock market multiples have ranged from 6 -30 times earnings in just the past 40 years the ramifications on the price of stocks is enormous. By the way, the multiple assigned is not just a stock market fiction. It can have real impact on a company’s fundamental health. For the higher stock price can meaningfully impact the cost of raising capital, essential for a growing company, and secondly it  impacts perceptions in the marketplace driving real customer demand.

So how might we analyze what a potential P/E multiple might be? Fundamentally P/E values should correspond with projections of a company’s future growth rate and the risk associated with achieving those growth rates. As all future seeing is, this can be highly complex, filled with considerable macroeconomic and company specific questions which must be addressed. But there is one important advantage. The Wall Street analysts spend less time on this part of the question because there are no specific formulae that one can employ. And companies themselves provide less guidance on these subjects because again it is more speculative and they fear any liabilities that might be assigned. Therefore, this is the far less efficient part of the stock price determination equation and as we have seen above, the far more impactful part of the equation. My suggestion is to spend a little less time on the facts and a little more time on the fiction (the less exact science of assigning a P/E multiple) if you want to find out where a stock may ultimately be going.

  ---The author, HUMMoney contributor Greg Lewin is currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.