A product’s value determines its price. For the stock market, that value has risen appreciably over the past 18 months. Small wonder, then, that stock prices are up likewise. Here’s the picture …
A word about estimated earnings
Stock valuations are based primarily on estimated earnings. However, some investors are wary of using these future forecasts. They have seen actual earnings vary widely from the estimates. In addition, the estimates themselves can shift over time.
However, these are not reasons to ignore the estimates. The variability and uncertainty are the risks associated with investing. Investing success depends on capturing future returns. That means forecasting the future is critical.
Even when making decisions using current or past information (e.g., dividend yields, payout ratio and dividend history), investors still make forecasts -- that the past is an indicator of the future. However, if future earnings fall, dividends (and any other measures) are put in jeopardy. So we are back to the importance of estimated earnings.
The key observation: The stock market is up, but valuations are not
Here are the past 18 months of earnings estimates alongside the DJIA. The dates chosen are primarily mid-quarter, capturing the effect of quarterly earnings reports.
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- Growth of 2010 estimated earnings from August 2009 = 14.9%
- Earnings growth rate from 2010 to 2011 (current estimates) = 11.7%