Written by Lance Roberts, Clarity Financial
The second-quarter earnings season started with a bang, with several companies reporting earnings “knocking the cover off the ball“.
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“Overall, 24% of the companies in the S&P 500 have reported earnings to date for the second quarter. Of these companies, 88% have reported actual EPS above the mean EPS estimate. Another 1% have reported actual EPS equal to the mean EPS estimate, and 11% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above the 1-year (83%) average and above the 5-year (75%) average.“
– FactSet
It is not surprising that stocks are rallying to new highs again this week with those kinds of numbers.
However, the longer-term problem for investors is that while the earnings were strong, they are only getting back to levels where they were supposed to be at the beginning of 2020. As shown, in January of 2020, the earnings estimate for the end of 2021 was $171/share. Currently, before estimates get downwardly revised, it is presently estimated that earnings will be just $174/share at the end of 2021.
As noted, the problem for investors comes down to valuations. For example, in January of 2020, investors were paying 19x for 2-year forward earnings. Today, they are paying 25x earnings for essentially the same dollar amount of earnings.
While it gets lost in the daily media, the reality is the price of the market is outpacing actual earnings growth. More importantly, when looking back historically, we see that earnings growth isn’t as strong as headlines suggest.
We certainly understand that valuations have very little importance in the short term. For now, all that matters is price momentum. However, as investors, it is essential to remember that valuations have great importance longer-term.
Sales Are Worse
Of course, such doesn’t even come close to premiums paid for each dollar of “actual sales” generated by the underlying companies. As we noted in “Priced For Perfection“, sales will decline this quarter, driving the price-to-sales ratio to historical levels. To wit:
“Investors should not dismiss the above quickly. Revenue is what happens at the top line. Secondly, revenue CAN NOT grow faster than the economy. Such is because revenue comes from consumers, and consumption makes up 70% of the GDP calculation. Earnings, however, are what happens at the bottom line and are subject to accounting gimmicks, wage suppression, buybacks, and other manipulations.“
Currently, the price-to-sales (revenue) ratio is at the highest level ever. As shown, the historical correlation suggests outcomes for investors will not be kind.
Currently, there are more than 70 companies in the S&P 500 trading above 10x sales. That is 14% of the entire index, one of the highest levels ever on record. (How many of these companies do you own?)
A Lesson From 2000
Why is that important? For that answer, let’s revisit what Scott McNealy, then CEO of Sun Microsystems, said in 2000.
“At 10-times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10-straight years in dividends. That assumes I can get that by my shareholders. It also assumes I have zero cost of goods sold, which is very hard for a computer company.
That assumes zero expenses, which is hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that expects you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10-years, I can maintain the current revenue run rate.
Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those underlying assumptions are? You don’t need any transparency. You don’t need any footnotes.
What were you thinking?”
Of course, much of this is “forgotten history,” as many investors today were either a) not alive in 1999 or b) still too young to invest. However, for the newer generation of investors, the lack of “experience” provides no basis for the importance of “valuations” to future outcomes.
That is something only learned through experience.
