Getting the Market Right: Alexander Green on the Importance of Earnings

Steve McDonald
by Steve McDonald, Bond Strategist, The Oxford Club

Transcript:

SM: Our guest this week is Chief Investment Strategist Alexander Green. He’s here to talk about earnings growth - and why he sees it as one of the key indicators for picking a stock successfully. Welcome, Alex.

AG: Hey, Steve. Thanks for having me.

SM: What is earnings growth, and why should our people be paying attention to it?

AG: This is what ultimately drives the stock market and individual share prices higher. Earnings, which are also called net income or profits, are what you get when you take the sales, deduct the costs, and find out whether a company is profitable and growing, and by how much.

The reason this is so important is stocks aren’t just blips on an electronic screen. You own a fractional share in a business, and you want to know exactly how that business is doing.

If you were buying a private business, you wouldn’t look at just the offices, factories and distributorships. You’d sit down and look at the books very closely. What’s happening to the earnings? What’s the trend? You’d want to find out everything you could about the company.

Benjamin Graham, Warren Buffett’s mentor, famously said that the stock market is a voting machine in the short term and a weighing machine in the long term. And in the long term, what it’s weighing is corporate earnings.

Companies that beat expectations by the biggest margins are the ones that give the best price action in the short term. So if you want a stock that will do well for you, you want to look at those earnings and correctly analyze whether they’re going to be better than expected.

SM: I know where earnings per share come from - it’s simple math. But where do they come up with the projections? Where do five-year earnings estimates come from?

AG: Those estimates come from analysts at brokerage firms and investment companies. These analysts are visiting the companies, talking to the executives, customers, supplies and competitors, and taking their gauge of the business. Then they’re making an estimate as to what they think the earnings per share will be in the future.

If you make $10 million in profit, and you have 1 million shares outstanding, then your earnings will be $10 per share. So if analysts thought the company would grow 10%, they’d be projecting earnings of $11 per share.

But of course, these numbers are conjecture. We can’t know for certain what a company will earn until the quarter has ended, the sales are tallied and the expenses are deducted to get that final number. But ultimately, these projections are made by various analysts. They average them out, and that becomes the consensus estimate.

If the consensus is that Company A is going to earn $0.50 a share, and then it actually earns $0.57 with an optimistic outlook from management, that’s called an earnings beat. That means investors get excited, and the shares go higher. If the reverse happens - if the earnings come in at $0.45 and the company admits it has problems - then shareholders will see the stock go down.

It really all boils down to earnings. Earnings drive the market higher, and earnings drive individual shares higher.

SM: If a stock has a 10% earnings growth estimate, can you expect the share price to match that increase?

AG: That’s a little too simplistic. For instance, a company that’s expected to grow 10% and has a lower P/E ratio could do much better than that. And if a company has a high P/E ratio and is growing by only 10% per year, that might be disappointing to investors, so the share price could go down.

Here’s the important thing, which I often mention at seminars: You can go back through history, and you will not find a single example of a company that increased earnings year after year and the stock price didn’t tag along.

These companies might sell off in the short term if earnings don’t go up as much as people hoped they would. But if a company just keeps growing, those shares will turn around and head back up. It’s about earnings, expectations, valuations and more. Shareholders are looking forward, not back.

SM: That nails it. Alex, thanks for taking the time to be with us today.

AG: It’s always a pleasure, Steve.

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