Earnings and Price Correlation Made Simple: Value Investing Style

Earnings and Price Correlation Made Simple: Value Investing Style

At their core, F.A.S.T. Graphs™ are easy to interpret and understand.  When you are clear on what the lines and shaded areas on a F.A.S.T. Graphs™ represent, you will experience an instantaneous and comprehensive understanding of the business behind the stock, and how the market has, and is, pricing it.

The Orange Line and Green Shaded Area

First, F.A.S.T. Graphs™ plots the earnings of the company and calculates its growth rate for the time period being graphed.  Then as a metaphor for intrinsic value, an orange line with white triangles is drawn based on applying widely-accepted formulas for valuing a business.  The orange line represents the same P/E ratio on every point on the graph and is also reported in the orange rectangle in the FAST FACTS box to the right.  The green shaded area is simply a mountain chart of the company’s earnings each year.

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For companies growing earnings at a rate of 15% or better, the classic formula P/E equals growth rate, commonly referred to as PEG, and made famous by Peter Lynch is applied.  Therefore, when a company’s earnings growth is 15% or greater, the orange line will have a P/E ratio that is equal to its growth rate.  When this formula is used, it is designated with the letters “PEG” in the orange rectangular box on the FAST FACTS to the right.  The following F.A.S.T. Graphs™ on Accenture is an example of a fast-growing company utilizing the PEG formula.

For the time frame graphed below, Accenture Plc (NYSE:ACN) achieved an operating earnings growth rate of 17.1% which is listed in the green rectangular FAST FACTS box to the right.  Then notice that the P/E ratio of Accenture’s orange line is also 17.1% which is equal to its earnings growth rate.  The designation PEG in the orange rectangle designates what formula the F.A.S.T. Graphs™ has used to calculate fair value.


Our second example is The Southern Company (NYSE:SO), a slow-growing utility stock whose operating earnings growth rate has only averaged 3.6% during the 11-year timeframe graphed.  Here we see the operating earnings growth rate of 3.6% shown in the green rectangle on the FAST FACTS to the right.  However, in this case the P/E ratio of the orange line is 15, and was calculated using the famous formula authored by Ben Graham.  The designation GDF, which stands for Graham Dodd Formula, is included in the orange rectangle in the FAST FACTS to alert the reviewer to the formula used, and to the growth rate the company has achieved.

Across the entire span of the graph, the P/E ratio in this low growth example is 15.  Additionally, the slope of the orange line in this example is 3.6%, or the earnings growth rate of Southern Company in this example.  Once again, the green shaded area represents a mountain chart of Southern Company’s earnings.


Our third example is Colgate-Palmolive Company (NYSE:CL), which has a moderate rate of operating earnings growth that has averaged 10% per annum.  When earnings growth is above 5% but below 15%, the P/E ratio is calculated utilizing an extrapolation of the two previous formulas (PEG and GDF) with the connotation PEG-GDF (note that the dash between them is not a minus sign, instead it is utilized to indicate that the extrapolated formula is being used).

Once again, the fair value P/E ratio that applies to the orange line is listed in the orange rectangle under the FAST FACTS to the right of the graph.  In the Colgate Palmolive example the P/E ratio of the orange line is 15 across the entire span of the orange line on the graph.  However, the slope of the line is equal to the company’s 10% growth rate, which is listed in the green rectangle in the FAST FACTS to the right.


To summarize, the orange line and green shaded area depict the company’s operating earnings during the timeframe graphed.  The intrinsic value, or P/E ratio, is calculated as listed in the orange rectangle in the FAST FACTS.  The earnings growth rate, which is also the slope of the orange line, is listed in the green rectangle in the FAST FACTS to the right of the graph.  Finally, the green shaded area represents a mountain chart of the company’s earnings.

More simply stated the orange line and green shaded area give you a graphic portrayal and instant look at the business behind the stock.  This is the most distinguishing and salient feature of the F.A.S.T. Graphs™ (Fundamentals Analyzer Software Tool) stock research tool.  Most other stock graphing tools plot price only.  As you will soon see, F.A.S.T. Graphs™ in contrast, reveals the earnings and price relationship of the stock and the business behind the stock.

Dividends are Expressed in Two Important Ways

First, dividends are expressed on the F.A.S.T. Graphs™ reflecting that they have been paid out, by the light blue shaded area sitting on top of the orange earnings justified valuation line.  Later when price is included on the F.A.S.T. Graphs™, you will see how the market prices earnings, representing capital appreciation and how the dividend represents the second component of total return – dividend income.  This is the primary reason why the blue shaded area representing dividends is included and depicted outside the green shaded area, which depict earnings.

Another advantage of expressing the dividends paid out in this manner is that the reviewer of the F.A.S.T. Graphs™ can instantly see whether or not a company pays a dividend, and for companies that have just started paying a dividend, they can also see when the dividend has first been initiated.


In addition to expressing dividends after they have been paid out by the light blue shaded area on top of the orange earnings justified valuation line, dividends are also expressed by a light pink line within the green shaded earnings area.  This serves two important purposes.  First, it allows the reviewer to instantly see whether dividends have grown consistently, or have been cut at any time during the timeframe graphed.  The pink line is simply a plotting of the company’s dividends each year utilizing the same multiplier that applies to the orange line on the graph.

When expressed this way, the second purpose of the pink line is to graphically illustrate the dividend payout ratio of the company.  The entire area below the pink line represents the portion of the earnings (the green shaded area) that are paid out and simultaneously expressed by the blue shaded area on top of the orange earnings justified valuation line.  In the case of our Church & Dwight Co., Inc. (NYSE:CHD) example below, the pink line also alerts the reviewer to any changes in the company’s payout ratio (Notice how Church & Dwight Inc.’s payout ratio increased dramatically in 2012 and 2013).  To understand this better, think of the area below the pink shaded area as a blank spot in a puzzle, and the light blue shaded area as the puzzle piece that would fit there.

This would still be true for a company with very cyclical earnings, however, the light blue shaded area could give the illusion that dividends were being cut because they are stacked on a rising and falling orange earnings line.  This is an additional benefit of the light pink dividend line, it will instantly reveal whether the dividend has been cut or lowered over the timeframe graphed.


Introducing Monthly Closing Stock Prices

The black line on a F.A.S.T. Graphs™ plots monthly closing stock prices for the timeframe being graphed.  When added to the earnings and dividend graph, the correlation between how well the business has done and how stock price has reacted and correlated is vividly revealed.  On graph after graph where earnings go the price is sure to follow.


The Blue Normal P/E Ratio Line

Moreover, and as an oversimplification, when the black line is above the orange line overvaluation is indicated.  When the black line is touching the orange line, fair value is indicated.  When the black line is below the orange line, undervaluation is indicated.  However, the real world does not always cooperate as planned.  There are certain companies that the market typically overvalues or undervalues, and the F.A.S.T. Graphs™ research tool reveals these situations when they occur by adding an additional line to the graph called the normal P/E ratio line (the dark blue line).

F.A.S.T. Graphs™ automatically calculates the P/E ratio that the market has most commonly applied to a given stock over any timeframe that is graphed.  This adds a second metaphor of valuation to the F.A.S.T. Graphs™.  It’s important to state here that F.A.S.T. Graphs™ were not designed to dictate fair value.  Instead, they were designed to reveal it.  In other words, it is up to the user to decide whether or not the blue normal P/E ratio line on the graph, or the orange earnings justified valuation line on the graph, is the right one to base valuation decisions on. The essence of FAST Graphs™ is that they are “A tool to think with.”

Therefore, with the Church & Dwight Inc. example below, there are two expressions of valuation included.  The blue

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Charles (Chuck) C. Carnevale – Co-Founder and Chief Investment Officer, has been working in the securities industry since 1970. He has been a partner with a private NYSE member firm, the President of a NASD firm, and a Vice President, Regional Marketing Director for a major American Stock Exchange listed company, and he was an Associate Vice President and Investment Consulting Services Coordinator for a major NYSE member firm. Prior to forming EDMP, Inc., he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.
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