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Why earnings are the golden goose of Wall Street

Why earnings are the golden goose of Wall Street

You cannot have a superstock without super earnings. And that is why earnings are the golden goose of Wall Street. And why earnings is used by most analysts to determine the financial health of a business. Because in the long term they drive stock prices up. Or down.

What earnings are

The term “earnings” can be somewhat confusing. Because the income, net income, and earnings often refers to the same thing. But the terms are expressed differently, depending on factors such as accounting. In essence these terms all refer to a company’s profits.

The earnings are the revenues minus the costs of producing a company’s products and services. Which is why analysts and CEOs obsess about them. Because the earnings gives clues about the price that investors will be willing to pay for that stock in the future. Since what is left, after costs have been paid for, is the company’s earnings and cash. And that is its intrinsic value.

Difference between earnings and cash

Cash is not quite the same thing as earnings. Cash is what the company spends to pay of debts and recurring costs of doing business. Compare it to your own wallet. You spend cash on things like food, rent and clothes. But that is not your earnings, right? Your earnings is what you have before you start spending that cash. So if you spend more than you earn your personal finances will suffer as a consequence. It is the same thing with a business.

To increase the earnings a business have to generate enough cash to be able to afford an expansion of its operations. Expansion is for example investments in new people, sales and offices. That happens with the cash that are left after recurring costs are paid. If those investments are successful they will lead to further increases in earnings. Therefore an above average earnings growth rate is a sign that the company is doing something right. Because they are spending their cash well.

If the business can’t generate enough cash it won’t be able to generate earnings increases. Because it will then have to raise money through selling assets, new stock or take on more debt instead of keeping the excess cash. Therefore the cash flow is important for the generation of earnings.

Why earnings are important

Earnings are important because they are the money that belongs to shareholders. And since the shareholders are the owners of the business the earnings are what drives the stock price in the long run. The earnings and the price follow each other because the price is what investors are willing to pay for those earnings. So if one moves up the other one will follow. Which can be seen if they are plotted together as two lines on a long term chart, as below.

This is a ten year chart of Berkshire Hathaway. Notice that the earnings have an almost perfect correlation with the price line over the long run. You could have bought the stock on several occassions when the price deviated below the earnings line. – Chart from Zacks

Especially over the long run the stock price and the earnings line moves in tandem. Long term falling earnings will correlate with a falling stock price and vice versa. But the earnings and the stock price might deviate from each other in the short term. And that often creates opportunities and market inefficiencies for traders like you and me.

Earnings per share

Earnings per share, or EPS, is often used to compare different companie’s earnings with each other. The calculation for EPS is to divide all the earnings by the shares outstanding. The EPS is a way to see what the company is worth in earnings. But divided into many smaller pieces. Different companies have different amounts of shares outstanding. As a result EPS shows how much profit a company is making per share. For example if two companies have the exact same number of earnings per year they can still have widely different EPS. Because their number of shares are different.

Earnings reports

Personally, I don’t trade earnings reports, because I don’t have that expertise. And I try to stick to my bread and butter, which is stockpicking. But there are traders that make money from trading these earnings reports. And on Wall street the period, when most companies report their earnings, is called “earnings season”. This period happens four times a year in most markets, for publicly traded companies.

Analysts comes up with ”earnings estimates” and forecasts before this happens. And when companies beat their earnings forecasts, they are said to ”beat their estimates”. When that happens the stock usually soars. Although that is not always the case. Because even if the company beat its estimates the stock could fall. For example if the expectations were higher before the report, among investors.

Earnings are seen in the technicals

Technical analysis will often hint of whether the future earnings will be good or not. Or if the stock is going to crash. Because the relationship between psychology, earnings and stock prices follows universal mathematical rules. For example we can see that below when Facebook’s stock price crashed in the middle of 2018, before its earnings started to fall.

Long term price and EPS chart of Facebook. The price is slowly starting to catch up again to its earnings in december 2019. Notice how correlated they are over the long run. – Chart from Zacks

Expectations

Sometimes investors overreact and get euphoric in their expectations of future earnings. This is sometimes expressed in market bubbles. For example in the dot.com bubble, of the late nineties, when the public and unprofessional investors went in and bought stocks when the market topped, on very unrealistic expectations. Thinking that they would keep on going even higher.

Both professional and unprofessional investors were caught up in the dot.com bubble. And many thought that internet stocks would rise forever. Talks were that the world was in a ”new normal” as expressed by the FED chair at the time, Alan Greenspan. But at the end of this bubble earnings came in short of expectations. And stock prices eventually collapsed as are seen below, at the peak.

The NASDAQ Dot-com bubble on a linear chart – Chart from TradingView

Now, in the rearview mirror, it was of course ludacris to think that profits would keep on going higher into infinity. But that doesn’t stop people from believing it.

Buy the rumour sell the news

Often it is the expectations of future earnings that moves the stock price. Which is also why stocks can crash hard on bad earnings reports. The Wall street expression ”buy the rumour sell the news” summarizes how a stock often behaves in relation to its earnings. Because often the stock price will increase until a certain event. For example an earnings report. But when that event finally happens the stock falls. Because the expectations were too high. Or already priced in. Conversely, if the expectations gets beaten, as they tend to be on Wall Street, the stock soars. And if they are beaten by a very large margin, the stock could skyrocket.

Dividends

If a company is earning a lot of profit it could pay this out as dividends to its shareholders. Which is one of the reasons why the profits makes the stock price go up over time. Because investors knows that this money will create value for them. Either through dividends or through a higher stock price. Or both.

On Wall Street there is a saying that ”dividends don’t lie”. But I disagree with that. Because there are several examples of companies that paid out dividends, all the way up until their bankruptcies, while at the same time making their earnings look good. Probably the most famous example is Enron. Since Enron kept paying out a dividend almost all the way up until its bankruptcy, in 2001.

In general the earnings growth hints of what the company will be worth in the future. And if it will be able to pay out substantial dividends to its shareholders. But there are no guarantees. In addition the company’s other fundamentals needs to be solid along with its earnings and dividends.

A word of caution on dividends

Dividends can be manipulated and actually hurt the business if they are paid when the company needs to do reinvestments or pay of debts. Therefore it is best to study them closely and together with other factors. Because in some instances they can be a way of a financially weak company to make their numbers look better. Or to please its shareholders by paying out dividends, even if they are not in a strong financial position. Therefore dividends have to be studied within their context.

Reinvestment

Instead of paying a dividend a company could reinvest their earnings into the business and develop new products. Typically smaller companies will reinvest their profits to create shareholder value through organic growth. While bigger mature companies pay out dividends. Which is why people looking for yield will typically buy big safe companies with a strong market position. While young cowboys like myself will typically go for the riskier fruit that have more potential, amongst the smaller companies.

Buybacks

A third way in which earnings can create shareholder value is through buybacks. This is when a company uses their proceeds to buy back their own shares. Which makes the share float smaller and the stock price rise. If done on an undervalued level this can increase the value for investors. But if a company buys back their shares on an overvalued level it is a sign that management don’t know what they are doing. Which is actually not that uncommon or even hard to understand. Because company managements usually don’t have backgrounds of being traders or investors. So they usually don’t know what makes a stock cheap or extensive.

If buybacks are done on an overvalued level the management is paying too much and spending resources in vain. But there are exceptions when the share buybacks have been done in very smart ways, on undervalued levels. Creating lots of value for shareholders.

Earnings growth

Earnings growth is what drives stock prices higher over the long run. And investors look at historic growth rates to get a clue about the future. The earnings growth was very important to the great investor Peter Lynch, who ran the Magellan fund between 1977 and 1990. Between those years his fund returned an annual compounded return of 29 percent. An investment of 10 000 would have become 280 000 dollars in those years. Peter Lynch said that the earnings growth and the stock price had a perfect relationship in the long run. The chart of the earnings and the chart of the stock price moves in unison over the long run.

When to buy

If the stock price dips down below the earnings line, on a chart, you might have found yourself a bargain. But to time your buy you might want to consider using technical analysis. And other fundamental indicators. For example one indicator that was important for the famous investor Peter Lynch, was the PEG-ratio. The PEG ratio measures price to earnings to earnings growth rate, and tells you something about the price in relation to its growth rate. And that might help you to time your buys. You can read more about the PEG ratio here.

Fast growing stocks will often have high price earnings ratios. Because investors want to pay more for that growth. Therefore the PE is not a good metric for understanding growth. The PEG ratio, on the other hand, will give you an idea of whether you pay too much for that growth or not.

Manipulated earnings

Earnings differ from cash in that they can include both cash and other revenues, which is not cash. For example sales on credit can be reported as earnings, even though the cash has not yet been received. Now, the cash flow should catch up with the earnings over time. But if the company don’t succeed in collecting the money that is owed to them, the current earnings are misleading.

The earnings can also be manipulated. For example a company could take on more debt and use their existing cash or sell of assets to make their earnings look better. Threfore earnings should always be studied along with other indicators and fundamentals.

Conclusion

To understand what makes a stock go up you need to have an understanding of earnings. Earnings are profits. And they are especially important to understand for a swingtrader like me, since they are the golden goose that drives stock prices higher over the long run.

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