Winning at Active Management

Chapter 9 The Jump from Company Earnings to Stock Prices

Reports on a company’s earnings, whether reported in terms of accounting earnings or cash flow, are by their nature historical. Investing, on the other hand, looks to the future. What economic profit is a company likely to create? What internal profit growth can it sustain, and what dividends and other returns will those profits afford to the owners of the business? And what do all these components imply in today’s market for the value of the company’s shares? A company’s history is often the best guide to its future, and deciphering past results and building them into a forecast of cash flows, and then into a prospective valuation, is the beginning of the investment process.

Flaws in Traditional Valuation Measures

Over time investors have devised many measures for turning up attractive stocks, by deriving the potential value of a share and comparing that estimate to its current price. One classic is a comparison of a stock’s price to its current or projected earnings per share—the price-earnings (P/E) ratio. Another is comparing the current price to the book value, which is the portion of a company’s net worth, according to the financial statements, that is attributable to each share. Both the ratios of price to earnings and price to book value per share can be easily calculated, and are widely used as shorthand measures of a stock’s price versus its true value.

But the P/E ratio and price-to-book value per share ...