Are Stock Prices Linked To Earnings?

Surprisingly, belying conventional wisdom, the link is too tenuous.

It is the most commonly used tool in the market. And often it is useless. If there is any consensus about investing tools in the stock market, it is two magical letters PE. From the most informed fund manager to the uninformed investor to the finance professor and the polished TV anchor, everybody seems to believe that PE is one of the most important determinants of investing. Implicit in the god-like status of PE is the belief that earnings and markets move up and down together. The greater the change in earnings, the greater is the movement in stock price. When earnings are up, it is time to buy, and when earnings are down, it is time to sell. When PE is low it is time to buy and when PE is high it is time to sell. Real life examples of the belief that stock prices are correlated to earnings are available everyday for all to see.

For instance, before the recent market decline fund managers have been vociferous in claiming that since the earnings are expected to go up 15-17% over this year, investors should expect a return of 15% over one year. How pat! The Sensex, instead of living up to this belief acted like a suicidal monomaic, shedding 3500 points over a month. The fall in Sensex did not diminish this belief. But does it actually work that way in real life? Here are some facts about Hero Honda during various periods. Look at the table:

• In September 01 and Dec 01, HH's net profit grew by 63% and 91% but   the PE hardly budged.

• When growth slowed, P/E started rising. In fact, when the net profit in   March 2005 and June 2005 declined by 2% and rose by just 8%   respectively, the PE went on to hit its all time high of 16. Maybe a quarter   is too short a time period to judge. So, consider some longer term   correlations:

• Net profit rose 88%YoY in the FY 02, but its P/E went on declining from   the high of 14 to 9 in the FY 02.

• In FY03 net profit rose 25% but the PE remained at 9. For the same 25%   rise in net profit next year, PE jumped to 15. In FY05, net profit growth   slowed down to 11% but PE remained at an all time high level of 16.   Clearly, far from earnings following valuation, the actual movement of   stock prices is random. The reality is in complete contrast to market the   theory. Assumptions about earnings being correlated to stock price are   completely opposite to the empirical evidence. PE as a predictive tool?   Think again