Understanding the importance of company earnings is crucial for investors looking to navigate the equity markets effectively. This article discusses how earnings impact stock performance and, in turn, influence the results of investment portfolios.
Key Highlights:
- Monitoring earnings growth is vital when investing in equities.
- While various factors—such as GDP growth, interest rates, and currency fluctuations—play a role, earnings remain the most significant driver of long-term equity returns.
- The price-to-earnings (P/E) ratio indicates how much investors are willing to pay for a company’s earnings. Shifts in the P/E ratio are fundamental to stock returns.
The Significance of Earnings
Company earnings reflect the profits generated after deducting operating expenses, and they are closely monitored by investment professionals for good reason. Over the long term, growth in equity earnings typically correlates with overall equity market performance.
Chart 1: S&P 500 Historical Performance and Earnings Growth
Source: Nutmeg, Macrobond (December 4, 2024).
It’s essential to recognize that the labour productivity metrics, such as output per hour, should not be viewed in isolation when evaluating economic health. The measurement of productivity, especially in the service sector, poses challenges, particularly for service-dominant economies like the UK.
Understanding Earnings Measurements
Earnings are commonly reported as earnings per share (EPS), calculated by dividing total earnings by the number of shares outstanding. This standardization allows investors to assess and compare earnings consistently over time.
There are two main ways to evaluate earnings:
- Trailing Earnings: This figure represents the earnings realized over the past 12 months and is considered reliable, though it reflects historical performance.
- Forward Earnings: This estimate projects the company’s earnings for the next 12 months, often based on forecasts from financial analysts. This forward-looking measure helps investors gauge expected future performance.
The Importance of the Price-to-Earnings Ratio
While earnings growth is crucial for achieving positive long-term equity returns, the P/E ratio also plays a significant role in market dynamics.
P/E Ratio Overview:
The P/E ratio is calculated by dividing the current share price by the earnings per share. It provides a multiple that investors are willing to pay for a company’s earnings.
For example, as of September 30 this year, the S&P 500 index had a value of 5,762 points, with expected earnings of 240 points. This results in a P/E ratio of approximately 24. Similarly, Microsoft’s share price stood at $429, with expected EPS of $13.50, yielding a P/E ratio of around 32.
Table: P/E Ratio Examples
| Index/Company | Price | Forward EPS | P/E Ratio |
|---|---|---|---|
| S&P 500 | 5,762 | 240 | 24 |
| Microsoft | $429 | $13.50 | 32 |
Source: Nutmeg, Macrobond (as of September 30, 2024).
Investors can use the P/E ratio to assess whether a stock or index appears “expensive” or “cheap” compared to its historical averages or relative to its peers.
Understanding Economic Drivers
Investment returns can be further analyzed by breaking down key components:
- Earnings Growth (EPS): Typically, if a company’s earnings rise, the stock price will follow suit, assuming the P/E ratio remains constant. For example, if a company’s EPS increases from $2 to $3, and the P/E ratio stays at 15, the stock price would rise from $30 to $45.
- Changes in P/E Ratio: A “rerating” occurs when the P/E multiple increases due to higher investor confidence or improved expectations for future earnings. This can lead to an increase in stock price even if actual earnings have not changed.
- Dividend Yield Contributions: In some markets, such as the UK, dividends can significantly contribute to overall returns. For example, in 2023, dividends added 1.7% to total returns, while growth in EPS contributed 6.6%, and the largest share of returns came from changes in the P/E ratio.
Conclusion
Investors can easily access technology companies that lead today’s digital economy. A long-term investment strategy allows you to capitalize on established giants while exploring evolving sub-sector themes.
Nutmeg’s portfolios provide a diversified exposure to both technology and broader equity markets. If you’re looking for more information on our thematic investment portfolios and how they might fit into your strategy, visit our dedicated webpage. If you have questions regarding various investment products, you can also schedule a free consultation with one of our experts.
Important Risk Warning
As with all investments, your capital is at risk. The value of your portfolio with Nutmeg may fluctuate, potentially resulting in a loss of your initial investment. Past performance and forecasts are not reliable indicators of future performance. Always conduct thorough research before making investment decisions.