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.
Factors in valuing a company’s stock
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.
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 not always an “apples-to-apples” comparison. “Determining fair value has a lot to do with the underlying growth rate of the industry in which the company competes,” says Haworth. In some cases, investors may be willing 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 steadier earnings, so the payoff on the investment needs to happen in a more compressed timeframe.”
Other variables can be reflected in the earnings they report. “It’s 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 business units, that may not reliably indicate future strength.
How earnings are reflected in the broader stock market
As they do with individual stocks, analysts can place a P/E valuation on the broader market. As of January 31, 2024, the P/E ratio of the S&P 500 based on earnings in the prior 12 months was 23.27, while the P/E ratio based on projected earnings for the next 12 months is 20.23.3 Analysts may set different valuations on the market based on varied sets of projections.
With S&P 500 P/E ratios based on projected earnings exceeding 20 times earnings, Haworth says the market may, on the face of it, look expensive, “but we’re in a different state now. Interest rates are elevated, inflation has come down significantly, so higher market multiples (P/E valuations) may be justified.” Haworth notes that technology-related stocks make up more than one-third of the S&P 500’s valuation in today’s market. “These companies are generally expected to realize faster, long-term growth rates, so they are often valued at higher multiples than other types of stocks.” Haworth believes that’s a factor influencing the current high valuations of the broader S&P 500 Index.
Preparing for the current environment
Haworth believes that earnings, while always an important consideration driving investor sentiment, may be overshadowed in the near term. “To this point, earnings for the broader market have mostly met investor expectations, so in the short term, the market has been more susceptible to fluctuation based on the Fed’s interest rate policy and economic data affecting the Fed’s position,” says Haworth. “Now we’re waiting to see what impact the direction of the economy will have on business and consumer spending and how that affects corporate profit margins going forward.” While positive stock market performance was mostly limited to technology, communication services and consumer discretionary stocks in 2023, Haworth says that investors continue to await “broader participation in the market, both in terms of stock price performance and earnings results from individual companies that did not experience favorable stock price results in 2023.”
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 professional to review whether changes to your investment strategy may be warranted to better reflect your goals, risk appetite and time horizon.