Wednesday, February 14, 2007

Relating earnings to stock price

Consistent growth in sales and profits reflects strong earnings power of a company. Investors need to check the company's financial performance before selling a stock.

How do I determine the earning power of a company?

As a result of higher investor confidence and stock prices, the market capitalisation of certain blue-chip stocks has surged to new highs.

Some analysts have started to revise upwards the target prices of these companies as a result of higher market valuation. It appears that the prospects of these companies have “suddenly” improved within a short period of time.

When we analyse their fundamentals, their sales, earnings or production capacity are about the same compared with the previous year's. Although certain companies may have shown better prospects due to some merger and acquisition activities, most of them have shown little change in their fundamentals. Yet, their stock prices have surged by more than 100% in less than a year!

We will not pay RM5,000 for a hand phone that is worth only RM1,000. However, we are willing to pay 5 to 10 times above the intrinsic value of a company during a bull market.

This may be attributed to our expectation of the future prospects of these companies. We may be able to judge the real value of a hand phone, but we have difficulty determining with certainty the future prospects of these companies.

Intrinsic value of the company
The fair price we need to pay for a stock will depend on the intrinsic value of the company. An investor needs to know the intrinsic value before making any purchase. According to Benjamin Graham in his book entitled Security Analysis, intrinsic value is an elusive concept.

He defined it as the price at which a stock should be sold if properly priced in a normal market and the value being justified by the facts, for example, the assets, earnings, dividends and definite prospects.

He also said the intrinsic value of a company could be determined by its earning power but admitted that it was very difficult to establish with precision a stock’s real earning power.

We can only provide an approximation on whether the value is adequate compared with its market price. However, we are unable to determine the exact intrinsic value.

Graham defined earning power as a combination of actual earnings, shown over a number of years, with a reasonable expectation that these will be approximated in the future. A company's strong earning power will imply that it has the potential to generate higher sales and earnings in future.

If the stock price of a company is highly correlated with its earnings, improved earnings will contribute to higher stock prices. If the current stock price does not reflect the strong earnings potential of the company, buying the stock at the current price can contribute to higher capital gain.

Method to determine the earning power

The following is one of the quantitative methods in determining the earning power of a company suggested by Graham. From the earlier definition, in order to check a company's potential earning power, we may need to trace its historical earning and sales performance.

The table shows the historical earnings of Transmile Group Bhd.

The consistent growth in sales and profits in the table reflects Transmile's strong earning power over the past six years.

Its stock price has also surged from the average price of RM1.81 in FY01 to RM12.45 in FY06. Any investor who had bought this stock at an average price of RM1.81 in FY01 should have made a handsome gain of 588% within a five-year period.

Unfortunately, most retailers would have sold this stock at around RM5.00 in FY04 as not many investors were able to resist the temptation of locking in their gains.

Given that most investors seldom check on the actual financial performance of a company, the decision to sell a stock would always depend on its original purchase price rather than the earning power of the company.

As a result, they usually miss the golden chance of making handsome returns from good fundamental stocks.

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