Back to the Basics on Stocks

There are two components to stock markets: earnings and how much investors are willing to pay for them. Recently, much of the commentary has been on valuations, with the implicit assumption that earnings would more or less take care of themselves. Although this has been the case for the past several years, at least on a per-share basis, one of my colleagues and an investment research associate, Sam Millette, recently pulled some figures that gave me pause.

There are several interesting takeaways from the numbers in the chart below, but the one that jumps out at me is that earnings (gross, not per share) always have grown faster than revenues. At some level, this makes sense. Companies learn, become more efficient, invest in better equipment, control costs, and so forth. In a well-run and growing company, earnings should grow faster than revenues. The question is, by how much?

Source: Bloomberg

A closer look at the data

Revenue growth. Looking at the data, revenue growth runs around 3.5 percent to 5 percent per year in all time periods, which is reasonably consistent with nominal GDP growth. Over time, revenues should be sustainable at these rates. Looking at specific time periods, though, there are differences. Revenues have grown slightly faster in the past five years, for example, than they have over longer time periods. This seems reasonable, as there’s no doubt that sales were depressed during the crisis and some of that is catch up. The numbers do suggest, however, that revenue growth might slow somewhat over the next several years.

Earnings growth. When we look at earnings, that narrow range and reasonable explanation seem a tougher fit to the recent data. Longer time periods show incremental earnings growth of between 1.70 percent and 2.34 percent—or about 6 percent based on an average sales growth rate of around 4 percent. Arguably, the 2000–2014 number is a better indicator, as it runs from a peak to a peak. But, leaving that aside, an extra 2.0 percent of earnings growth over revenue growth seems reasonable.

When we look at the most recent data, however, that increment of earnings growth over revenue growth has been more than 9 percent. It can certainly be argued that the depth of the collapse was such that we should see extra earnings growth in the aftermath, in line with the higher sales growth over that same time period. Given that argument, however, there is a problem: The math requires earnings growth to drop significantly over the next several years to make the averages come out even close for the full cycle. Success so far is probably a prescription for a significant slowdown soon.

Per-share numbers. And what if we consider the per-share numbers? One of the features of the past five years has been massive share buybacks, with companies reducing the number of outstanding shares and, consequently, increasing the per-share growth rates. It is surprisingly hard to quantify some of these effects, but I’m taking a look at it and hope to write about it soon.

The time is now

As we have seen, valuations certainly matter. But we are rapidly approaching a time when the earnings cycle will start to turn, and the fundamentals—the earnings—will take center stage again. Looking at the math, the act to come might be a lot more difficult for investors than the past one. The time to think about it is now.