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Earnings season

April 19, 2018

Last Thursday was the kick off for “earnings season.” This is the traditional start of the period when a large number of companies post their quarterly earnings. Question: Why is this significant?

Many companies are selling at prices not based on earnings, in particular Tesla, Amazon.com and Netflix. Yet, earnings are considered significant. Actually, earnings are a major factor that drive stock market values. Growing sustainable earnings reflect itself in higher market valuations, so Wall Street eagerly awaits the reports, and then seems to do what it wants anyway, but in the long run, earnings drive the valuations.

There are always exceptions and we have our share of them, but they are not so plentiful, so let’s overlook the exceptions and concentrate on the huge majority of companies. No matter how you want to value a company, growing sustainable earnings is the key element. Extensive specialized equipment, secret processes, pipelines of new products, undervalued land and buildings, company franchises and cash hoards are all nice but at the end of the day, it is the profits generated by the configuration of assets that determines the value, i.e. stock prices; and therefore the fuss over earnings.

A simple metric used to measure value is the price to earnings ratio or P/E. The P/E is determined by dividing the share price by the earnings per share (eps). For instance if the stock is selling for $30.00 and the eps is $2.00, the P/E will be 15 (30 ÷ 2). If the eps was $1.50 the P/E will be 20; if $3.00, the P/E would be 10; and if 75₵ the P/E would be 40. The greater the earnings in relation to the price, the lower the P/E, and the P/E would be higher for companies with low earnings per share. Generally optimistic stock owners will accept a high P/E while the risk adverse will seek out stocks with lower P/Es. A company with a traditionally low P/E would be considered cheap while one with a traditionally high P/E would be considered expensive. Sometimes the PE is based on future expected earnings and company growth giving a high P/E or a languishing company will have that condition reflected in a very low P/E.

Some specific comments about the current earnings cannot be overlooked by me. Many of the earnings’ reports include a one-time income recognition due to the reduced corporate tax rates. This is not sustainable yet is included in the earnings reducing the P/E ratios. Those companies that are reporting losses due to a write down of their deferred tax assets seem to be getting a bye and their prices do not seem to be dropping. The tax winners will not have gains of this magnitude in later years so that should cause future earnings to drop with a corresponding change in their P/E.

Current stock fluctuations seem to be politically based with concerns about possible trade wars, potential Federal Reserve actions, the midterm elections, hoped for economic growth or the suspected burgeoning of the federal deficit and growth of our national debt and its effect on inflation and interest rates. These will right or normalize themselves over long periods of time and that is why I suggest that investing in the stock market should not be done unless you are prepared to leave the funds in the market for at least seven years.

Earnings do drive prices. How and when is an unknown and possibly a mystic process, but over long periods, i.e. seven or more years, it seems to work. In the meantime, do not get too caught up with earnings season, but look at the long term.

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