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At the special request of a reader, we are reviewing Big Lots (NYSE:BIG) in this article. The Earnings and Price Correlated graph on Big Lots tells the story of a cyclical company with a rather erratic operating history. We believe this is important information for prospective investors to know.

Earnings Determine Market Price

The following earnings and price correlated F.A.S.T. Graphs™ clearly illustrates the importance of earnings. The Earnings Growth Rate Line or True Worth™ Line (orange line with white triangles) is correlated with the historical stock price line. On graph after graph, the lines will move in tandem. If the stock price strays away from the earnings line (over or under), inevitably it will come back to earnings.

According to the company website:

Big Lots is North America's largest broadline closeout retailer. As of Jan. 28, 2012, we operated 1,451 Big Lots stores in the 48 contiguous United States and 82 Liquidation World and LW stores in Canada. Wholesale operations are conducted through Big Lots Wholesale, Consolidated International, and Wisconsin Toy and with online sales at biglotswholesale.com.

Earnings and Price Correlated Fundamentals-at-a-Glance

A quick glance at the Historical Earnings and Price Correlated FAST Graphs™ on Big Lots shows an inconsistency of earnings through 2006 (see EPS, highlighted in green). In more recent years earnings have advanced, and the price looks undervalued based on the historical earnings growth rate of 6.1% (orange circle) and a current P/E of 12.7 (blue circle). You can see by looking at this graph that earnings have flattened in 2012 (orange line).

Big Lots: Historical Earnings, Price, Dividends and Normal P/E Since 1998

Click to enlarge images.

Performance Table for Big Lots

When performance is presented separately like shown below, you can clearly see that if purchased as of Dec. 31, 1997, the rate of return for shareholders of this name becomes undeniably evident. Long-term shareholders of Big Lots, assuming an initial investment of $1,000, would have received a total return of -0.2% per annum vs. 2.4% for the S&P 500.

However, if you shorten the historical Earnings and Price Correlated graph to eight years, you can clearly see the correlation between price and earnings. As seen in the graph below, as earnings began to rise so did price. As previously mentioned, note a flattening of earnings in 2012. In many cases, when a company can be purchased at or near its intrinsic value based on earnings and cash flow generation, the shareholders' rate of return, or long-term capital appreciation, will inevitably correlate to and/or equal its earnings growth rate.

Overvaluation will lower that rate of return, and conversely, undervaluation will increase it. Consequently, paying strict attention to the valuation you pay to buy a stock is a critical component of both greater return and taking lower risk to achieve it. Because, ironically, when you overpay for even the best business, you simultaneously lower your return potential while increasing your risk of achieving the lower return.

By purchasing this company as of Dec. 31, 2004, just before earnings advanced, the improved rate of return for shareholders becomes undeniably evident. Long-term shareholders of Big Lots, assuming an initial investment of $1,000, would have received a total return from 17.6% (highlighted in orange) per annum vs. 4.5% (red circle) for the S&P 500. Note that this rate of return closely correlates to the accelerated earnings growth rate during this time period.

The following graph plots the historically normal P/E ratio (dark blue line) correlated with 10-year Treasury note interest. Notice that the current price earnings ratio on this quality company is as low as it has been since 1998.

A further indication of valuation can be seen by examining a company's current price-to-sales ratio relative to its historical price-to-sales ratio. The current price-to-sales ratio for Big Lots is 0.50, which is historically normal.

Looking to the Future

Extensive research has provided a preponderance of conclusive evidence that future long-term returns are a function of two critical determinants:

1. The rate of change (growth rate) of the company's earnings.

2. The price or valuation you pay to buy those earnings.

Forecasting future earnings growth, bought at sound valuations, is the key to safe, sound, and profitable performance. The Estimated Earnings and Return Calculator Tool is a simple yet powerful resource that empowers the user to calculate and run various investing scenarios that generate precise rate of return potentialities. Thinking the investment through to its logical conclusion is an important component toward making sound and prudent commonsense investing decisions.

The consensus of 16 leading analysts reporting to Capital IQ forecast Big Lots' long-term earnings growth at 12% (orange circle). Big Lots has low long-term debt at 8% of capital (red circle). Big Lots is currently trading at a P/E of 12.7, which is inside the value corridor (defined by the five orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, Big Lots' True Worth™ valuation would be $87.92 at the end of 2017 (brown circle on the EYE chart), which would be a 14.4% annual rate of return from the current price (highlighted in yellow).

Analysts are forecasting the earnings growth to continue at about 12%, and when you look at the forecasting graph (Estimated Earnings and Return Calculator) below, the stock also appears undervalued (it's inside of the value corridor of the five orange lines -- based on estimated future growth). History shows this stock to be somewhat volatile. Investors should be ready for a bumpy ride even with advancing earnings and especially if there is any type of earnings miss.

Earnings Yield Estimates

Discounted Future Cash Flows: All companies derive their value from the future cash flows (earnings) they are capable of generating for their stakeholders over time. Therefore, because Earnings Determine Market Price in the long run, we expect the future earnings of a company to justify the price we pay.

Since all investments potentially compete with all other investments, it is useful to compare investing in any prospective company to that of a comparable investment in low-risk Treasury bonds. Comparing an investment in Big Lots to an equal investment in 10-year Treasury bonds illustrates that Big Lots' total expected earnings would be 8.4 (purple circle) times that of the 10-Year T-Bond Interest. (See EYE chart below.) This is the essence of the importance of proper valuation as a critical investing component.

Summary and Conclusions

This report presented essential "fundamentals at a glance," illustrating the past and present valuation based on earnings achievements as reported. Future forecasts for earnings growth are based on the consensus of leading analysts. Although with just a quick glance you can know a lot about the company, it's imperative that readers conducts their own due diligence in order to validate whether the consensus estimates seem reasonable or not.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation. A comprehensive due diligence effort is recommended.

Source: Stock Research Analysis For Big Lots