Surely not the only one, I am a firm believer that earnings drive stock prices. Especially in the long-run, company earnings are usually positively correlated with the stock price. Picking stocks with sustainable above-average earnings growth can then lead to superior investment returns. However, one should be aware of the price which he pays. As Warren Buffett's famous mantra states: 'Price is what you pay, value is what you get.'
This approach of combing the tenets of growth and value investing was widely popularized by legendary investor Peter Lynch who was employing various indicators to determine whether a stock is worth to buy. Besides the well-known PEG ratio, Lynch was frequently using what is today called the Peter Lynch earnings line and compared it with the actual price chart.
The Peter Lynch earnings line is nothing else than the price of a stock at some fair PE multiple with respect to the earnings growth. In other words, you take the EPS and multiply it by the average or expected value of PE ratio. If the current price is below the resulting figure, the stock is undervalued, and if the current price is above the product, the stock is overvalued.
Obviously, successful investment decisions in practice are not as simple as more factors come into play. Nevertheless, Peter Lynch earnings line can serve well for making a quick notion where the stock stands. It can be particularly useful for valuing companies with relatively stable earnings growth and diversified high-growth high-PE businesses such are most internet stocks.
One of them is certainly Shenzen-based Tencent Holdings Ltd. (OTCPK:TCEHY), an operator of WeChat - most popular instant messaging platform in China with more than 700 million monthly active users - and several other fast-growing companies. Because of the rapidly growing dynamics of the group, it is almost impossible to come with a reasonable estimate of intrinsic value using traditional valuation methods, and statistical analysis of price and earnings growth can provide better insights.
Looking at the historical PE multiples at which Tencent's shares traded, it becomes apparent that the stock price was driven by earnings growth during the period illustrated in the graph below. Based on quarterly data, one could have purchased the stock at a PE from 13.3 to 65.3 and always made money.
On the other hand, the graph of year-over-year quarterly diluted EPS growth shows that the earnings growth is slowing. By how much? Well, the exponential trend line reveals that the average year-over-year quarterly earnings growth approximately decreased from 55% to 20% over the past decade.
Assuming the company will more or less sustain this 20% growth rate over the next 5 years, the fair PE ratio can be set at 20. With this information, we can easily construct Peter Lynch's earnings line for the stock.
Since the price line has recently jumped over the earnings line, the intuition of the concept tells us that the stock is overvalued. This result can be verified by calculating the CAGR of quarterly closing price and quarterly diluted EPS from the income statement. And indeed, price of the stock has risen faster than its EPS. Over the period captured in the graph above, Tencent's shares rose at a CAGR of 47.6% while Tencent's quarterly EPS' CAGR reached just 35%.
Overall, the numbers are still pretty impressive as most of the publicly-traded companies are not capable of increasing profits in the long run. Hence, one should rather focus on the slope of the earnings line and close his eyes to the recent divergence between shares' price growth and company's earnings growth. Even though the current PE multiple struggles to justify the expected earnings growth rate, I would say Tencent's shares are still a buy. If no accounting malpractices come to light in the next few quarters, earnings and price momentum will drive the shares higher. With respect to no margin of safety with this stock, I would recommend placing a trailing stop loss order and seeing the shares in the context of the whole portfolio rather than as a flagship holding.
Disclosure: I am/we are long TCEHY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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