Key takeaways
Of the 11 industry sectors represented in the S&P 500, six reported negative year-over-year earnings growth for Q4 2022.
Most notable is weakness in the technology sector.
Even some of the largest companies reported earnings pressure due to slower economic growth and lingering supply chain challenges.
Stock prices move up and down for a variety of reasons, but over the long term, no factor may be more important than corporate earnings. Earnings represent a corporation’s net profits and are of great interest to investors and analysts as they assess the financial health of a company and the potential of a stock’s performance. Earnings expectations often help drive the direction of the broader stock market.
As important as earnings are to the calculation of a stock’s value, it is far from the only factor that comes into play. “If all you had to consider was current earnings, expected earnings and how inflation affects those numbers, it would be simple to judge a stock or the outlook for the markets,” says Rob Haworth, senior investment strategy director at U.S. Bank. After all, the financial health of a company – as reflected by earnings – represents the most fundamental consideration in valuing equities. “But at times, other factors overshadow earnings and may have an outsized impact on stock prices,” notes Haworth.
Several weeks after the end of each calendar quarter, most publicly traded companies provide an updated report on their earnings for the previous quarter. Results for fourth quarter 2022 earnings began to be reported in January 2023. Notably, with more than two-thirds of companies represented in the Standard & Poor’s 500 Index reporting now, earnings are down 2.3%. While reflecting slowing profit growth, these results are considered modestly better than expected.
Of the 11 industry sectors represented in the S&P 500, six reported negative year-over-year earnings growth. Most notable is weakness in the technology sector. Even some of the largest companies (Apple, Alphabet, Amazon) reported earnings pressure due to slower economic growth and lingering supply chain challenges. The narrow majority of industries reporting negative earnings growth is considered a potential cautionary sign. With expectations of slower economic growth, more pressure on corporate profits through much of 2023 is anticipated.
What should investors know about corporate earnings, how can they determine the most important signals earnings send to the markets, and how can one incorporate earnings in assessing investment prospects for stocks?
The publicly traded companies represented as stock holdings in your portfolio deliver quarterly financial statements that include a wide range of information. This includes a breakdown of sales (revenue) and expenses, the two key factors that determine earnings. Earnings represent a company’s after-tax net income, or profits.
Earnings information is important because it provides a glimpse into the company’s business success in recent months. In many cases, companies provide “guidance” regarding their future earnings and growth prospects. This guidance serves as a preview of what may come based on trends companies are experiencing in their businesses. While companies are routinely expected to provide earnings guidance, it doesn’t always occur. Haworth notes due to the economic uncertainty created by the onset of the COVID-19 pandemic, companies have issued advanced guidance about upcoming earnings reports with less consistency.
Professional stock analysts often estimate, in advance, their own expectations for what companies will report each quarter. “Investors are very attuned to the forward-view of earnings, which reflects the stock market as a discounting mechanism,” says Haworth. In other words, stock prices are based less on a company’s past performance and more on expectations of future financial success. “Stock prices typically incorporate a consensus market belief about the future state of a company, including earnings, growth prospects, risks, pricing challenges and other factors,” says Haworth.
Earnings provide the basis of one of the major measures of a stock’s individual value. Investors often use a statistic known as the Price-to-Earnings (P/E) ratio to help assess how expensive a stock is relative to the rest of the market. In other words, it is the ratio of the current price of a stock compared to the company’s earnings. If a stock is trading at $30 per share and the company’s annual earnings are $2/share, the P/E ratio is 15.
“Now we’re waiting to see what impact the direction of the economy will have on consumer and business spending and how that affects corporate profit margins going forward.”
Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management
P/E ratios are often expressed in two ways, trailing and forward. Trailing P/E reflects how the current stock price measures up against earnings over the previous 12 months. For example, in early February 2023, the P/E ratio for the largest stock in the U.S. market, Apple Inc., was 25.61. That reflected its current share price in relation to earnings generated over the previous 12 months. A second way to assess valuation is by looking at P/E ratios reflecting anticipated (forward) earnings over the next 12 months. On that basis, the P/E ratio for Apple Inc. stock is slightly lower, at 24.69.1 P/E ratios are generally expected to be lower when based on forward earnings rather than on trailing earnings, as companies typically are expected to grow their income year-over-year.
Haworth notes that P/E ratio is just one measure of a stock’s performance. “We look at a variety of valuation assessments, including sales growth and book value growth, which is essentially a way of estimating the liquidation value of a company.” Other factors would include a company’s cash flow and a stock’s dividend yield.
When trying to assess which of two stocks offer the best investment opportunity based on their P/E ratios, it’s important to recognize that it’s not always an “apples-to-apples” comparison. “There can be variations in the expectations for different kinds of stocks,” says Haworth. “Determining fair value has a lot to do with the underlying growth rate of the industry in which the company competes.” Some stocks may be viewed with a longer lens, as investors demonstrate a willingness to bid up prices based not on current earnings, but on expectations of future profitability. “This tends to be the case, for example, with stocks that invest in new technology that may not have an immediate payoff but offer the potential of future strong earnings if they succeed,” says Haworth. “Other stocks may have lower P/E multiples, but those companies generate more steady earnings, so the payoff on the investment needs to happen in a more compressed timeframe.”
While companies’ financial statements may seem straightforward, variables can be reflected in the earnings they report. It’s important to be able to understand the numbers that are most applicable to a stock’s valuation, and what might not be as pertinent.
“It is worth reading beyond the headline numbers,” says Haworth. “Unique, one-time events may affect earnings, either positively or negatively.” For example, if a company’s earnings declined due to a one-time major expense, that shouldn’t necessarily reflect poorly on its outlook. Similarly, if a company reports a strong boost to earnings, for example, because it sold off one of its units of business, that may not reliably indicate future strength.
Analysts often use earnings estimates to determine whether the broader stock market is fairly valued. For example, earnings of the S&P 500, an index of approximately 500 large company U.S. stocks, totaled $207.81 per share as of the third quarter of 2022, according to Factset Research Systems. The anticipated change in that number going forward can provide investors with a broad sense of the market’s valuation.
As they do with individual stocks, analysts can also place a P/E valuation on the broader market. As of January 31, 2023, the P/E ratio of the S&P 500 based on earnings in the prior 12 months was 19.17, while the P/E ratio based on projected earnings for the next 12 months is 18.4.2 Analysts may set different valuations on the market based on varied sets of projections.
If earnings are assumed to be the most fundamental measure of a stock’s or market’s value, there are times when earnings are overshadowed. For example, in 2022, while corporate earnings were generally improving, stocks suffered a significant decline.
“In 2022, three primary factors shifted investor sentiment,” says Haworth. “High inflation, the Federal Reserve significantly raising interest rates and slower economic growth. Investors anticipated that all these factors would have a negative impact on the business environment, and ultimately, on corporate earnings.”
Markets experience such periods when non-market factors, some economic, some triggered by other events such as a geopolitical conflict or a health care crisis like the COVID-19 pandemic, overshadow current fundamentals related to earnings.
Haworth believes that earnings have returned as a primary focus for investors in 2023. “Now we’re waiting to see what impact the direction of the economy will have on consumer and business spending and how that affects corporate profit margins going forward.” He notes that in the early months of 2023, there appear to be many unanswered questions about the direction of the economy. How that is resolved will likely determine whether stocks can regain strength over the course of the year.
As you assess your investment options and how to best position your portfolio, it can be helpful to do so in the context of a financial plan. Talk with your U.S. Bank wealth specialist to review your current financial position and review whether any changes to your investment strategy may be warranted to better reflect your goals and time horizon.
The U.S. Bank investment team anticipates that in 2023, the Fed’s tighter monetary policy will contribute to decelerating economic growth, with inflation remaining a concern.
Don’t let market volatility and an uncertain economic outlook derail your disciplined investing strategy.
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