The investment industry is replete with pundits and self-proclaimed experts espousing various principles and rules that allegedly are the best way to value a stock correctly. Unfortunately, and in most cases, these rules are stated as fact, but unfortunately very few facts are ever presented to back them up. In other words, much of it is either opinion or gleaned from something they've read or been taught before. But even as a young boy, I was never willing to accept dogma as fact without simultaneously being provided supporting evidence and a logical explanation as to the "why" that they work.
In fifth grade I was once sent to the principal's office by my English teacher because I made her cry. She cried because every time she would regurgitate a rule of grammar, punctuation or spelling, she expected me to accept it unconditionally, merely because she said so. For example, she would say something like I before E except after C expecting me to simply accept this rule as fact. I, on the other hand, not meaning to be argumentative or disruptive, only inquisitive, would immediately raise my hand in class and ask a simple question-why? No matter what rule she would state, I would relentlessly raise my hand and ask okay, but why? I was not willing to have the rule dictated to me; I needed to understand why it was the rule and why it was important.
Now that I am an adult, I have continued to embrace my inquisitive nature, and to this day I will not accept a dogmatic statement without understanding why. On the other hand, when I can review supporting evidence that validates the rule and therefore understand its significance, relevance and validity, then and only then, through my understanding it, can I embrace it willingly and passionately. Therefore, as an author of financial articles, I believe my readers should hold me to this same standard that I hold others to. Consequently, this article is designed to illuminate the "why" behind widely accepted notions of valuing a business primarily based on earnings (discounting cash flows).
When Investing in a Business Earnings Determine Intrinsic Value
In his best-selling book One Up On Wall Street, famed portfolio manager Peter Lynch dedicated his entire 10th chapter to earnings and thus titled it –Earnings, Earnings, Earnings. In the chapter's second paragraph he succinctly stated the importance of earnings as follows:
"There are many theories, but to me, it always comes down to earnings and assets. Especially earnings. Sometimes it takes years for the stock price to catch up to a company's value, and the down periods last so long that investors begin to doubt that it will ever happen. But value always wins out-or at least in enough cases that it's worthwhile to believe it."
An important foundational principle behind this discussion is the idea that we are talking about investing as part owners of strong businesses, rather than trading stocks. Business owners are rewarded through the profits the companies they own are capable of generating on their behalf. These rewards can come in the form of salaries and bonuses for active owners, and from increasing value or cash flow from dividends for passive shareholders. In either event, all these rewards are ultimately a function of the businesses' earnings capability, at least in the longer run. Therefore, we should realize that when you truly invest in a stock, you really are investing in its ability to earn more money for you in the future.
When I first read Peter Lynch's famous book in 1990, I had already developed a strong belief in the importance of earnings regarding assessing the fair value of an operating business. Therefore, the theory behind Peter Lynch's wisdom already resonated deep within me. However, as already stated, it was the facts behind the theory that interested me the most. In fact, I was so committed to the notion that earnings determine market price, that I developed my own stock graphing tool that allowed me to evaluate the true relationship between a company's earnings and its stock price over time.
The following additional quotes from Chapter 10 of Peter Lynch's book titled: Earnings, Earnings, Earnings, speak to the importance of valuing a business based on its earnings power:
"you can see the importance of earnings on any chart that has an earnings line running alongside the stock price…. On chart after chart the two lines will move in tandem, or if the stock price stays away from the earnings line, sooner or later it will come back to earnings."
A few pages later, Peter offers us another nugget of wisdom on the earnings and price relationship, plus a little bit of investing advice thrown in:
"a quick way to tell if a stock is overpriced is to compare the price line to the earnings line……. If you bought familiar growth companies…… when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you would do pretty well."
Now that we've reviewed some investing axioms and nuggets from Mr. Peter Lynch, let's see if we can perform two extremely important tasks. First and most importantly, let's see if we can answer the more important question as to why earnings determine market price; not just that it does. Next, let's produce some evidence that verifies the veracity of Mr. Peter Lynch's words. In order to accomplish both of these important tasks we will rely on visual representation, and mathematical proofs provided by F.A.S.T. Graphs™.
How to Value a Company's Earnings and Why
The essential point underpinning the thesis of this article, is that when you're investing in a business you're not actually buying the stock, you're buying the company's earnings power. The stock is only the vessel that contains the earnings you are purchasing. When buying earnings, the principles of value apply just like they do with any other product or service. The easiest way to understand this clearly, is to think in terms of the price you pay to buy $1 dollar's worth of one company's earnings versus $1 dollar's worth of another company's earnings.
In other words, let's look at two companies to see what the price, and therefore, value, of $1 dollar's worth of earnings are. However, before we do, let's establish some doctrine that we are going to focus on. First and foremost, remember that we are going to buy $1 dollar's worth of earnings for each of our two companies. Now, we need to clearly understand that once either of those dollar's worth of earnings are taken out of the business and put into our pockets, the value of each dollar's worth of earnings is precisely the same.