Earnings Power vs. Investor Sentiment

When we invest in stocks based on fundamentals, one truth eventually becomes clear. Over the long-term a stock can only perform as well as the company. If a company goes bankrupt the stock will eventually become worthless. Alternatively, if a company can grow its earnings over decades the stock will grow. Because the market is not efficient, discrepancies in a stock's relation to intrinsic value comes and goes. When there are high expectations combined with greed, like there was during the 1920s and late 1990s, stocks go beyond cosmic bunny-hole valuations. A company cannot grow earnings over 50% forever. A company's share price will only grow as much as its earnings over the long-term.

In this article I am going to present 5-year charts of a variety of companies with trailing 12 month earnings. What you can see in many of them is a deviation from their earnings power. This happens because of many things: apathy, optimism (like we will see with SunPower Corporation (SPWR)), pessimism and fear. I would really like to get charts that span for decades with these variables. If anyone knows of a free online site that has this, shoot me an email or leave a comment.

To get a sense of how to value alternative energy companies over the long-term, let's talk about the topic of replacing our dependency on oil and non-renewable resources. We are not even in the beginning of the alternative energy expansion. Based on the business history of the United States, I am predicting major technological innovations will replace old technology driven by fuel provided by petroleum and coal. I would even disagree with Warren Buffett's recent purchase of stakes in Railroads as a solid multi-decade investment. If the price of horse carriage manufacturing companies were cheap in the 1890s, would you buy them right before Ford's Model T? Railroads shouldn't be around much longer. I could be getting ahead of myself, though, and a switch may be a century away. We will see, though. Technology changes fast, even faster today than before because of international competition.

Some Examples

SunPower Corporation (SPWR), Solarfun Power Holdings Co. Ltd.(SOLF) and other alternative energy companies are currently valued based on expectations of high long-term growth. I'm not saying these stocks are going to drop anytime soon, but these valuations cannot last for many years. In the 1800s, railroads were overpriced. In the 1960s, investors in IBM (IBM) were expecting growth of earnings over 15% for perpetuity. Investors were wrong. Both were corrected. Let's see if we can find the price of some stocks straying from their intrinsic earning power.

I think it is now safe to say that Starbuck's (SBUX) was very overvalued over the last few years. This chart would agree. Starbuck's shares are being adjusted to its long-term earnings potential in a more competitive and saturated coffee market. A company that will grow earnings at 15% to 20% in the future can't remain at 50 times earnings for long. I am not saying that these charts are the end all of valuation. Some stocks will carry a high valuation for years and decades. It is interesting to see Starbuck's tumble though while maintaining a good brand and somewhat predictable cash flow and earnings. There eventually will come a time due to the pessimism that it is extremely undervalued.

click on all charts to enlarge

Let's see how two of the biggest banks, Citi (C) and Bank of America (BAC) have held up. The banks' earnings troubles have been pounced on. You can even see a possible shorting opportunity in both Citigroup and Bank of America as the stock rebounded in the face of extreme pessimism and lowered earnings.

Circuit City (CC) follows the same trend of the stock being punished for lowered earnings.

Best Buy (BBY) saw continued rising earnings but an uncalled for drop in share price which has recently been corrected in the last two quarters.

Let us take a look at Apple (AAPL). As James Cullen shows with a growth model, Apple may be straying from from its intrinsic value. The chart below would reveal the same. Click on the charts to see a larger image. We see strong investor optimism without change in the long-term realistic earnings growth story. No matter how great Apple's new products sell in the short term the "invisible hand" of the industry and economy will re-adjust Apple's profits.

Here is the one you have been waiting for, SunPower (SPWR).

Home Depot (HD) has seen trouble due to the real estate bubble collapsing. If earnings improve the stock is looking undervalued. The same goes for Chinese Jeweler LJ International (JADE), which has not even seen a drop in earnings but only an increase in investor fear.

In conclusion, it is a sound investment strategy to look for companies that have stable, predictable earnings and pessimistic investor sentiment. The intrinsic value of stocks based on future earnings growth will change but investors' moods are far more volatile. In a future analysis I might compare current GDP growth with overall stock prices in the US and China, so keep tuning in.

Disclosure: Author is long LJ International (JADE) and has no position in SunPower Corporation (SPWR), Solarfun Power Holdings Co. Ltd.(SOLF),IBM (IBM), Starbuck's (SBUX), Citigroup (C) and Bank of America (BAC), Circuit City (CC), Best Buy (BBY), Apple (AAPL), Home Depot (HD)

Comments

[likeparty]

yahoo provides a "max" chart which shows pricing back to the inception of the stock.

[awcabot]

Regarding Apple, your analysis assumes that consensus earnings is reasonably accurate. And yet for the past 5 years Apple has handsomely beaten analyst expectations and with the most current quarterly report coming up it seems that again Apple will deliver better than expected results.
The point when Apple becomes a mature and slowly growing company like Starbucks or some railroad company seems to still be quite far away.

[Hugo vander Vlist]

Regarding Apple, the red dots of the consensus estimate are still going up, but not as much as in the past year. However, at this moment in time it is very hard to predict Apple's earnings, because they have only just started in the phone business. It looks like they are doing extremely well in that department, so it is only logical that earnings estimates will rise in the coming year, something that's not yet reflected in the chart. And Apple has a massive amount of money to start another new venture if they wish to do so, like television, navigation or gaming. Don't forget they are doing very well in the PC business too. So I'm not too worried about the share price of AAPL.

[jwest]

I agree with awcabot, Apple is just at the beginning of a growth curve, not at the end of one. Your chart misses a huge metric that the consensus estimates have not accounted for- market share for the Mac. The ipod & iphone make the news, the mac makes the money. With the highest price tag and margins, this is where Apple makes most of it's profits. WIth the help of the ipod & iphone, the Mac has now been "discovered" by the mass media and general public. Apple is looking at over 40% growth in market share for the Mac vs 2006. Earnings for 2008 will be staggering. The only adjustments to your chart in 2008 will be up!

[ponto]

Hi Mark,
Good article, I would love to see more charts with earnings overlayed on price-- what was your source for these charts?

[ThinkFirst]

There are a couple of serious problems with your analysis. Others have mentioned one problem, i.e. that consensus estimates by analysts may be under- or over-estimating true earnings power. The second problem is that there is no right way of overlaying earnings with price. Take Best Buy for example. If you move the earnings line up, you get a far different picture. The way you have drawn the lines, you are leading viewers to conclude that Best Buy is a sell because, at some point, the price has to come down to touch the earnings line. But, if the earnings line were drawn above the price line, somebody who viewed the graph would conclude that Best Buy is undervalued. Neither conclusion would be valid from a simple glance at the overlay chart. I hate to say this but, such simplistic analysis is practically worthless.

[MKY]

Concerning BEST BUY the current stock price, by some estimates, is grossly undervalued. That ofcourse happens all the time. But, looking at your graph, one could draw a quick visual conclusion that BBY is grossly overvalued. Looking closely at your graph reveals that BBY should be valued at around $50 which is indeed the case. But looking at it visually one could reach incorrect conclusions. Mr. KiritVora brings this aspect to highlight and perhaps, you might be able to bring about a closer alignment visually. Other than that, I found your article very helpful and informative. Please keep sharing your excellent insights for the readers.

[jmmx]

Well – there is a lot to say about this article!

First off – the points are well taken: it is common for stocks to run up too far for their intrinsic value, to “get ahead of themselves.” Also – it is not possible for any company to maintain 20% or higher growth rate indefinitely.

That said, however, there are several points to be made. First, what the author has described (and charted) is simply the commonly known relationship the P/E ratio.

One real problem with the article, is that the charts are not normalized – they do not illustrate a common P/E ratio. The implied ratios for the charts (very roughly calculated) are:

Stock P/E
Starbucks 25
Citigroup 8
BoA 12
Circuit City 20
Best Buy 10
Apple 25
Sunpower 25
Home Depot 11
LJ International 24



And so the charts show that the prices for BoA and CC both track earnings almost exactly. One, however, has a P/E of 12, the other of 20. The graph for BBY also tracks the EPS closely (if you smooth). It is, however, constantly above the EPS line implying that it is overpriced. Yet, today its P/E is only 15.5. If we look at Starbucks graph, we see that the price recently crossed under the EPS line. From the article one would guess that the author was suggesting that this was the “correct” valuation, and now that the price was below the line, the stock is now somewhat oversold. BUT, at the crossover, the P/E appears to have been around 31 – way different from the P/E of crossovers on the other graphs. So what SHOULD the P/E of a stock be?

That of course is the proverbial $64,000 question. But if you look at the table comparing the estimated earnings rise, it seems as though people will give a higher P/E for a higher growth rate. That is pretty much what we expect. In fact, for the high growth stocks, it seems like people are paying about 25 P/E for the EPS expected 2-3 years out. Perhaps that is not unreasonable??




Stock 2003 2011 % Current P/E PEG
Starbucks 0.30 1.75 580 21 0.85

Citigroup 2.8 3.5 125 7.6 1.80

BoA 3.0 5.5 183 9 1.91

Circuit City 0.6 0.6 100 xx NA

Best Buy 1.2 4.2 350 15.5 0.98

Apple 0.25 * 10 4000 46 1.61

Sunpower
(start 12/30/2006) 0.25 * 5 2000 637 2.48

Home Depot 1.6 3.2 200 10.4 0.87

LJ International
(start 1/30/2004) 0.2 0.40 200 15.50 NA

* - estimated

[jmmx]

As for Apple...

if you look at the yahoo chart of competitors (sorry but formating does not seem to work here, but you can see:
finance.yahoo.com/q/co...)

Here you can see that Apple is at the top of most of the measures of value - especially forward growth. So little wonder if it is at the top of the P/E valuation.

----------
Apple DIRECT COMPETITOR COMPARISON (from Yahoo)
AAPL DELL HPQ MSFT Industry
Market Cap: 157.64B 49.50B 120.64B 321.64B 49.50B
Employ_ees: 21,600 83,300 172,000 79,000 21.60K
Qtrly Rev Growth (yoy): 28.50% 8.50% 15.20% 27.30% 2.70%
Revenue (ttm): 24.01B 59.61B 104.29B 54.07B 24.01B
Gross Margin (ttm): 33.97% 18.75% 24.36% 78.41% 33.97%
EBITDA (ttm): 4.73B 4.11B 11.48B 22.07B 4.11B
Oper Margins (ttm): 18.37% 5.97% 8.42% 37.87% 5.62%
Net Income (ttm): 3.50B 2.99B 7.26B 14.88B 2.99B
EPS (ttm): 3.931 1.325 2.677 1.524 1.33
P/E (ttm): 45.80 16.67 17.51 22.56 36.67
PEG (5 yr expected): 1.61 1.24 0.98 1.52 1.61
P/S (ttm): 7.11 0.89 1.23 6.12 0.83
-------------

With something like 7% Mac usage, there is lots of room for growth. Since a major factor in the growth is the word-of-mouth recommendations, and Mac has by far the highest scores here, I think the growth could continue at 40+% for the next two or three years - barring a recession of course.

I think people have not really comprehended the extent of the Mac revolution that is underway. As the basis for this point of view, I take not only the recent accounts of the growth in Mac market share, but also this very informative article:

Is Tech Support Getting Worse?
ARTICLE DATE: 09.13.07
By Eric Griffith
.
www.pcmag.com/print_ar...
.
Ostensibly on tech support, the article gives other info from their survey.
.
Let me give a couple of findings reported:

* "Of course, no Windows machine comes close to Apple's 9.1 overall score... the 93 percent score for new desktops working right out of the box."

* "What's left to say? If you buy a Mac, not only will you in all likelihood love it, but you're also going to recommend it to your friends while enjoying all the time you can spend not fixing it."

* "And readers scored Mac notebooks a full 100 percent for ease of setup. Simply amazing."

* "And the numbers show that people already using Macs almost always recommend Macs. The score of 9.4 out of 10 for Apple is the highest ever seen in any of our surveys."

This last quote is the most important of all - for here lies the crux of my argument. If 94% of Mac users are recommending them then they will have some effect on their friends and fellow workers. Let us suppose that ON THE AVERAGE each of these users convinces just 2 other people to buy a Mac. This does not have to mean that they become impassioned advocates - just adding in the final "I love mine" into a discussion might be enough. The two keys: 1- Ease of use, 2- Reliability..
This is exponential growth! I can see Apple having 40% of all new sales in 5 years (perhaps even in 4). Sounds ridiculous - but remember - they OWN the Mac OS, if you choose Mac OS then you must buy a Mac. That is a lot of computers.
.
In my humble opinion. -- jmmx

[David Lentz]

Nice article, sparking substantial discussion.

The fly in the ointment, as pointed out, is the fallibility of the "consensus estimates" of future EPS values. If they were at all reliable, stocks would never stray from those lines.

But in truth, they're ALMOST ALWAYS low when earnings are doing well, due to the intersection of the tendency of companies to lowball guidance, and the tendency of analysts to lowball estimates (it's much better for an analyst to make estimates a little under actual reported earnings than to err on the other side), and they're ALMOST ALWAYS high when earnings sag, as the causes for sagging earnings are normally not predictable and tend to arrive as a surprise.

Picking localized highs/lows to sell/buy at turns out to be usually no better than throwing darts. I find that if I track PE vs time for any given stock, one can see when it is historically on the high side, and also when it approaches the lower range of historical PE fluctuation. It can hug the upper/lower end of the range for quite a while, but usually in bubbles or recessions, there is often a distinct spike that makes a reasonable point at which to buy/sell with a bit lower risk over a reasonable time period (1-3 years) that the decision will work out.

If you're a day trader, with short time horizons, then none of this matter to you, as your universe is a matter of hours/minutes, not weeks/months/years.

That's about as reliable a thing as I can find.

Looking forward, the possibility of a significant recession with rising unemployment might make for a buying opportunity in AAPL, with it declining to something around 130 as the water goes out of the stock PE pool, and all the boats go lower, NO MATTER WHAT THEIR EARNINGS ARE DOING.

But even if you bought it on New Year's Eve for about 200, you would likely be profitable within a year, and making respectable profits in a couple of years.

Of course, if you bought in near 130 at the bottom of this hypothetical recessionary blood-letting, ... well, in that event you should send me some money to celebrate on 12/31/2008. Good Luck.

[jmmx]

David - on the last recession scare, Apple bumped down almost exactly to its 100 day EMA (low 150.63 EMA aprox 150). If it were to repeat that in the next couple of days, the current EMA (100) is about 168.)

This is quite a ways from your 130 - but it we hit a real recession...

Best of luck - and see you in December. :)

jmmx - in Portland Orygun (where it is raining)

[moneygardener]

Interesting article, but I agree with other comments about P/E contraction etc. You can use this type of basis to invest though assuming 1.consistent companies 2. low P/Es

[fxtrader07]

just to remark: railroads have been around for centuries now. you suggest they may be replaced soon. may i ask: by what other new means of bulk transportation? any suggestion?
just curious since you sound a bit as the death of railroads is just around the corner (just by a few decades)

[Mark Perkins]

KiritVora and others. I didn't intend for the charts to be the end all of valuation, rather, just something to think about along with my ideas.

fxtrader07, It is just something to think about as alternative energy becomes more common. Yes, it could be soon or as I say "centuries." It will happen eventually though. Just look at how the world and technology has changed so fast in so little time after the Industrial Revolution. airplanes, cars, jet propulsion, subs, computers etc. were not here 180 years ago.

Thanks for the feedback.

[Mark Perkins]

last one is me.