A quick look at a timely topic of interest - with a brief review of why it could matter to investors.

Chart of the Week

July 28, 2014

It's what you keep, Q2: corporate earnings vs. sales
S&P 500 earnings per share and sales per share

chart

Source: Bloomberg and S&P 500, as of 7/11/14. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The bottom line:

  • Q2 corporate earnings are off to a good start, beating estimates for the most part.  As of July 17, nearly two-thirds of the 84 S&P 500 companies reporting so far have beaten their 2Q14 estimates—according to S&P Dow Jones.
  • As in recent quarters, earnings are growing more quickly than sales. If operating earnings for the remaining companies come in as expected, it would mean about a 6.6% jump in earnings from 1Q14 – and a 12.4% increase from last year's 2Q results.
  • To a great degree this reflects disciplined management and expense control—a positive sign of continued corporate health.
  • The market appears to have taken notice: stock indexes have been rising more quickly than either sales or earnings. The S&P 500 rose 22% between 6/30/13 and 6/30/14, nearly twice the pace of earnings, pushing up the price/earnings (P/E) ratio for the index from around 16 to about 17.5.
  • But behind the scenes, a more intriguing investment challenge could be emerging: market valuations overall are higher. At the same time, there is greater focus on the sustainability of profit margins already at historic highs.
  • With the market more fully valued, bottom-up stock selection—seeking to identify individual companies more attractive than the market overall—is arguably more critical.
  • What makes a company more attractive in this context? Sustainable growth and/or pricing power; strong  cash generation; and long-term competitive advantages, whether based on product innovation or overall industry trends

The chart:

  • The chart shows annual S&P 500 operating earnings and sales per share on a quaterly basis.
  • Earnings per share for June 2014 through December 2015 are based on S&P estimates.
  • Sales per share data shown is from December 2005 through June 2014.

Context & Perspective:

  • Earnings per share progress has been strong this reporting season, with the tally so far suggesting an overall increase of 6.6% from 1Q12, and 12.4% from the same period last year. But the story is quite a bit different for sales per share – which has increased much more slowly – rising just 0.3% in 2Q14 and only about 4% from 2Q13.
  • The difference is for the best of reasons – an increase in the profit margin of the S&P 500, from 8.4% in 2Q13 to 9.4% in 2Q14.
  • The solid increase in annual earnings would certainly be welcomed—the previous year's 2Q increase was just 0.6%. That improvement helps validate the S&P 500's strong advance in 2013, when there was little earnings growth.
  • The key issues for each factor:
    • Revenues –S&P 500 sales per share $1,119.5 for 2Q14, according to Bloomberg. That represents a 0.3% increase from $1,116.2 in 1Q14 and 1.3% increase from $1,104.9 in 4Q13. Sales were up 3.95% from $1,076.94 a year ago. Acceleration in revenue growth is likely needed to support reasonable earnings growth.
    • Margins - The S&P 500 profit margin was 9.41% in 2Q14 roughly in line with 9.45% and 9.55% in 1Q14 and 4Q13 respectively. A year ago the profit margin was 8.44%. The average since March 1990 is 6.25%. While we may have entered a period where technological developments could sustain margins at higher than average levels, the jury is still out on whether they can be sustained at a level that is 50% above average.
    • Earnings - S&P 500 operating earnings for the 12-month period ended June 30, 2014 is forecasted to be $111.61, based on S&P Dow Jones estimates as of 7/11/14. That represents about a 2.5% increase from $108.85 in annual earnings at the end of 1Q14 and about a 4% increase in annual earnings from $107.30 in 4Q13. As previously mentioned, annual earnings were up 12.4% from $99.28 a year ago.
    • S&P 500 price level – Recent earnings growth seems to have validated at least some of the market's move higher from mid-June 2012 through 2013.  Between June 2012 and September 2013, the S&P 500's price level increased 22.3% even though annual earnings increased just 8.7% during the same time period causing some to question if the market had disconnected from fundamentals. Yet for the past three quarters now, annual earnings growth has been 10.8%, 10.7% and 12.4% (forecast) respectively. Meanwhile, the S&P 500's price increased 16.6% from the end of September 2013 through June 2014.
    • Price-to-Earnings (P/E) ratio – The S&P 500's P/E ratio was 16.2x in June 2013 and only 14.8x in June 2012. Based on expected earnings for June 2014, the P/E ratio is 17.6x – a level that many believe denotes a fairly valued market, and which reflects the market's recognition of solid improvements in profitability.  The forward P/E, based on expected 2015 earnings of $136.50 is about 14.5x given an S&P 500 price level of 1,985.

Definitions:

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.

The price-to-earnings (P/E) ratio is a stock's (or index's) price divided by its earnings per share (or index earnings). The forward P/E ratio is a stock's (or index's) current price divided by its estimated earnings per share (or estimated index earnings), usually one-year ahead.


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