How Earnings Drive Stock Values and Shareholder Returns: Part I

How Earnings Drive Stock Values and Shareholder Returns: Part I

By Chuck Carnevale of Fast Graphs

I want to start this article out with the positioning statement, that I am a fundamental investor, and that I believe in conducting a comprehensive fundamental evaluation on any Company (common stock) that I buy, or for that matter, hold or sell. My own personal core investing philosophy is about investing in businesses and not the stock market.  Consequently, it is only through a comprehensive analysis of the company’s fundamentals that the investment merits of an operating business can be analyzed and evaluated.

This thought leads me to providing an explanation of why fundamental analysis is important, and why I believe it should be conducted by prudent investors who are interested in owning good businesses rather than trading stocks.  When all is said and done, the real purpose behind conducting a comprehensive fundamental analysis is to determine the core, or innate earnings power of the business that is being evaluated. This is critically important to the fundamental investor because, at the end of the day, earnings determine market price over the longer run.  This is why earnings are referred to as the bottom line.

At the heart of my thesis, is the real-world reality that the “stock market” values a business by capitalizing the company’s earnings power in the long run.  Later in this article, I intend to demonstrate this with real-world examples that clearly illustrate the veracity of this thesis. In other words, if a thesis is truly valid, we should be able to measure it and produce real evidence supporting its validity.  When you think about it, whether people are doing it consciously or subconsciously, most rhetoric you will find by investors discussing their favorite, or least favorite stock, will relate to their expectations of the business’ earnings power. They may not state this directly, but if you read between the lines it becomes readily apparent that the company’s earnings power is what is on their minds.

I often produce reports where I analyze the merits or demerits of a specific publicly traded stock. Invariably in the comment section that follows my article, readers will often provide commentary regarding why they think the company I’ve written about is a good or bad company.  They will talk about things like the risk from competitors with newer and better offerings or the loss of a patent on their key drug, or how great or bad they believe the current management team is, or the strength or weakness of their balance sheet, and the list goes on and on. But behind it all, the commentary is consciously or unconsciously discussing each commentator’s belief about the company’s future earnings power, good or bad.

Now, the idea that earnings determine the value of a business (company) will often generate an upheaval of dissenters that will offer their own favorite fundamental metric for valuing a business.  One of the most common that is embraced and defended by many analysts is cash flows. Their argument is principally based on the notion that cash is cash, and earnings are optional. Frankly, there is a lot of truth behind their position, and I would add that I believe that when trying to determine the intrinsic value of a company, cash flows are one of the primary fundamental metrics that I scrutinize heavily.

However, there are numerous additional important fundamental metrics that the true fundamental investor should also consider and utilize in attempting to evaluate the strengths and value of any business they are looking at. Others, to name only a few, would include things like net profit margin, return on total capital, return on shareholder equity, retained earnings to common equity, the price to sales ratio and of course cash flow per share.  In other words, when attempting to ascertain the value of the business, examination of the underlying fundamentals is essential. And, when trying to understand the quality of the company’s earnings power, cash flow analysis is one of the best tools available.

At this point, I would like to emphasize that behind any of the fundamental metrics I have already mentioned and all the ones that I haven’t, are numerous mathematical formulas that are utilized to produce the quotient being measured. However, the purpose of this article is not to provide a college course that goes into great detail illustrating and/or explaining all of the complex mathematical algorithms and formulas behind how fundamental metrics are derived.  Instead, my goal is to provide the essence or common sense rationale behind each of these important fundamental values.  And, in this regard, clearly illustrate not only why they are important, but how the everyday investor can use them to their ultimate benefit.

Therefore, right off, I admit to oversimplifying many of these complex concepts in order to focus on their importance and potential benefit.  Consequently, I will take some liberties with the precise mathematical proofs, in order to focus on the practical applications and rationale behind the true value to investors of fundamental analysis. Because, I believe that by explaining these things in a more sensible context, the reader will be able to determine for themselves whether or not they can benefit from these activities.  We will leave the details and the mathematical formulas to the professional analysts, while focusing instead on the essence and practical ways to think about these fundamental principles.

Therefore, let’s start from the top and work our way to the bottom.  When analyzing a company, I always like to start with the top line, more commonly known as sales (gross revenues).  Investors, professional and lay alike, need to remember that all the other important metrics, especially cash flows and earnings, ultimately come from the top line.  If there are no sales, or if a company’s sales are weak or dropping, then it’s only rational to recognize that future cash flows and earnings will respond in direct proportion to what’s happening to the company’s top line, in the long run. So to me at least, I believe one of the best indicators of the true health of a business is to first evaluate the strength of its sales.

Again, as I will later demonstrate, evaluating a business is analogous to the famous children’s song Dry Bones: the toe bone connected to the heel bone. The heel bone connected to the foot bone.  The foot bone connected to the ankle bone, etc. etc. etc. With a business, the top line (sales or revenues) is connected to the middle line (cash flows and free cash flows), the middle line is connected to the bottom line (earnings). Consequently, for sake of this article, the top line is sales, the middle line is cash flows, and finally the bottom line is earnings. All of them are connected, and therefore, functionally related to each other. Therefore, one is not more important than the other, because they all are tied together.  But most importantly, the prudent fundamental investor considers them all before making a final investment decision.

On the other hand, when trying to determine the fair value of a business, it is only the bottom