To some investors, the market is like an elaborate lottery, pulling in money from everyone and paying it out to a lucky (or connected) few. Peter Lynch addressed that challenge in chapter 10 of "One Up on Wall Street," showing how earnings are the reality that inevitably temper stock prices.
The critical linkage
He began the chapter by asking the critical question all investors face:
“What makes a company valuable, and why it will be more valuable tomorrow than it is today?”
For Lynch, it ultimately meant two things: Earnings and assets, but especially earnings. While earnings and prices may go on separate paths for long periods, the price will eventually get close to earnings again. Value, he said, will always win out, or at least often enough to believe in that connection,
“Although it’s easy to forget sometimes, a share of stock is not a lottery ticket. It’s part ownership of a business.” [author’s emphasis]
Lynch followed that up with an exercise of the imagination: If you were a stock, in which category would you fit? Those categories were slow grower (sluggard), medium grower (stalwart), fast grower, cyclical, turnaround and asset play. Look at yourself and the people around you and ask how much earnings potential each one has.
The earnings line
In this chapter, Lynch laid out the important relationship between the earnings line and the price line. As I’ve hinted in previous chapter reviews, his theory is the earnings line is a constant and the price line fluctuates around it. When the price line gets above the earnings line, then it’s generally time to sell and when the price line gets well below the earnings line, then a potential buy situation is presenting itself.
This is a 10-year chart for Union Pacific (UNP, Financial) showing the price line (green) and the earnings line (blue); the earnings line simply connects annual or quarterly earnings data. These two lines make it a Peter Lynch chart and, as noted, we want to watch when the price line moves above or below the earnings line. Currently, price is well below the earnings line, signalling a potential buy:
While price generally stays near the earnings line for the first half of the chart, Union Pacific becomes overpriced between early 2013 and late 2017, then underpriced as earnings shot up in 2018. Lynch also emphasized the primacy of the earnings line:
“People may bet on the hourly wiggles in the market, but it’s the earnings that waggle the wiggles, long term. Now and then you’ll find an exception, but if you examine the charts of stocks you own, you’ll likely see the relationship I’m describing.”
Price-earnings ratio
Of course, there is a way to summarize all the information on a Peter Lynch chart with just one number: The price-earnings ratio (also called the price-earnings multiple). Lynch called it numerical shorthand for the relationship between price and earnings and considered it a reasonable measure of a stock’s valuation in relation to the company’s potential to make money.
Union Pacific’s price-earnings was 10.18 on July 25. That’s based on a share price of $145.17 and trailing 12-month earnings of $14.26; dividing the former by the latter calculates the ratio. In December 2014, around the time the price line hit a high compared to the earnings line, the price-earnings ratio was 20.68.
The ratio also tells investors how many years it would take them to get all their capital back, assuming the earnings remain constant. A price-earnings ratio of 10.18 means 10 years and a bit, far better than the 20.68 years in 2014. Lynch added that price-earnings levels “tend” to be lowest for slow growers and highest for fast growers.
If there is one thing he wanted investors to remember about price-earnings ratios, it was this:
“Remember to avoid stocks with excessively high ones. You’ll save yourself a lot of grief and a lot of money if you do. With few exceptions, an extremely high p/e ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse.”
The market price-earnings
Think wheels within wheels: the stock market has a price-earnings ratio of its own, comprised of all the individual company ratios and that provides a reasonable indication of the overall market’s valuation. Lynch added:
“I know I’ve already advised you to ignore the market, but when you find that a few stocks are selling at inflated prices relative to earnings, it’s likely that most stocks are selling at inflated prices relative to earnings.”
Between 1982 and Black Monday of 1987, Lynch reported he saw the market price-earnings ratio creep up gradually, from about 8 at the beginning of the period to about 16 when it ended. To put that another way, investors in 1987 were prepared to pay double what they did in 1982 for the same earnings.
In addition, interest rates can have a material effect on price-earnings ratios because investors are willing to pay more, per unit of earnings, for stocks when interest rates are low and bonds are unattractive.
Future earnings
Once again, Lynch has taken us back to a hard question: How much will earnings be in the future? For starters, knowing the current earnings and price-earnings ratio will help investors avoid overvalued stocks, and that will make a big difference in the future.
But, in the longer game, the forecasting gets tougher. As Lynch said:
“Battalions of analysts and statisticians are launched against the questions of future growth and future earnings, and you can pick up the nearest financial magazine to see for yourself how often they get the wrong answer (the word most frequently seen with 'earnings' is 'surprise').”
What you can do, though, is find out how a company plans to grow its earnings, then check back to see if it is sticking to the plan. And has the company delivered on past plans?
Generically speaking, there are five ways a company can increase its earnings:
- Reduce costs.
- Raise prices.
- Expand into new markets.
- Sell more products in existing markets.
- Fix or exit money-losing operations.
What has the company been saying about these subjects in previous annual reports? And, stay tuned: Lynch promises more insights in the next chapter.
Conclusion
In chapter 10 of "One Up on Wall Street," Lynch has given a tutorial on earnings, and on the relationship between earnings and prices.
As in regression to the mean, prices keep finding their way back to the earnings line, although not necessarily right away. The earnings line is a constant, while the price fluctuates around it.
Not surprisingly, Lynch also addresses the price-earnings ratio, the latter here signifying the earnings line. Divide the stock price by the most recent earnings to get a numerical value and a guide to how long it will take to recover invested capital. The stock market also has a price-earnings ratio, based on the ratios of all the stocks within it. Use this number to assess whether the market is overvalued, undervalued or fairly valued.
Most important, perhaps, was Lynch’s discussion about future earnings, which is what all investors are buying. There are no crystal balls, but seeing what management plans to do and has handled previous plans and growth provides important insight.
GuruFocus provides the Peter Lynch Screen tool for quickly finding companies that meet his criteria. Members can access the screener here, and non-members can get started here.
(This review is based on the Millennium Edition (2000) of “One Up on Wall Street.” More chapter-by-chapter reviews can be found here.)
