Price Earnings Ratio, Earnings Growth

By fulfilling customer needs, increasing the business efficiency and leveraging profits, Dell Computer managed to sequentially increase earnings almost every quarter of the 1990's decade with a few exceptions. Through earnings growth Dell succeeded in propelling the stock price forward. The following section is a discussion of why earnings growth drives the stock price.
 
Before describing the principles let’s define some Earnings Growth terms: Earnings equals net profit after taxes
Earnings growth equals the rate of change of earnings over a period of time.

• Price Earnings Ratio (PE ratio) equals stock price(P) divided by earnings(E). The math equation would read:  
  Price Earnings Ratio = Price/Earnings or
  PE ratio = P/E

Rearranging the mathematical equation by multiplying both sides of the equation by E one can rewrite the equation to read:

• Stock Price(P) equals the Earnings(E) times the Price Earnings Ratio(PE ratio) or
  P = E x PE ratio
  

If the Price Earnings Ratio remains a constant then the price of the stock is directly proportional to the earnings of the stock. This leads to the first principle

Earnings growth principle:
If company earnings are growing at a set rate over a period of financial quarters, and the Price Earnings Ratio remains the same, then the stock price will rise at the same rate of the earnings growth rate.  The fuel that propelled Dell’s stock price was earnings growth. Dell’s earnings grew 16 fold from 1990 to 1996, while the average annual Price Earnings Ratio bounced between 8 to 13(Value Line) and the resulting price of the stock rose 17 fold. Note that the significant portion of the stock move was directly attributable to the rise in earnings, while the Price Earnings Ratio stayed in a fairly narrow range.  

Let’s look at an example of how earnings growth can spur stock price growth:

Given:
Company XYZ
Stock Price (P) = $10.00 per share
Earnings original E(o)= $1.00 per share
Earnings final E(f) = $4.00
Earnings Growth (EG) = 300% 

Calculate Price Earnings Ratio
If a company with a stock price of $10 per share earns $1.00 per share, then the Price Earnings Ratio is $10 per share divided by $1 per share Price Earnings Ratio equal to 10 or mathematically

• Price Earnings Ratio = Share price/Earnings per Share
  PE = P/E
  PE = $10/$1 = 10
  

Let’s assume the next year the company earnings quadruple or grow at 300%. The company now earns(E) $1 per share plus $1 times 300% for a total of $4.00 per share mathematically

• Earnings = Original Earnings + Original Earnings times earnings growth
  E(f)= E(o) +E(o)*EG
  E = $1 + 1x300% = $4.00
  
  

If the the Price Earnings Ratio remains steady at 10, and earnings rise to $4.00, then the price of the stock is equal to Price Earnings Ratio times the earnings per share $40 per share or mathematically

• Stock Price = Price Earnings Ratio x earnings final
  P = PE * E(f)
  P = 10 x $4 = $40
  

The price of the example stock must rise from $10 per share to $40 per share in order to maintain the same PE ratio, thus the 300% earnings growth  resulted in a 300% rise in stock price. Put another way, $10,000 invested in the company stock would be worth in $40,000 after one year. If earnings quadruple again the following year, this $10,000 original investment in company stock would grow to $160,000 in two years, if the Price Earnings Ratio continues to remain constant.

How to calculate earnings growth

The math….

Earnings growth (Eg) or (EG) equals Earnings Final(Ef) less Earnings Original(Eo) divided by Earnings Original (Eo) multiplied by 100%

Eg = (Ef – Eo)/Eo x 100%

 
In a later chapter of this report tools will be reviewed to screen for growth rates.  We note for purposes of math and simplicity the earnings growth principle states the Price Earnings Ratio “remains the same” however, company earnings are issued quarterly and remain fixed until the next quarter. Prices meanwhile fluctuate daily, thus in the shorter term, thus in reality price earning ratio vary daily along with the price changes.  
Reflecting back upon the equation
P = E x PE ratio,

If for a moment the Earnings (E) are held steady or constant then the price of the stock is directly proportional to the Price Earnings Ratio of the stock. This leads to the second principle that will be reviewed in Part 5.

Stock Trading Key Terms: 

• Earnings:  The income of a company usually calculated on a quarterly basis and often described as earnings per share
• Earnings Growth: The percentage of growth of income over a given period of time
• Price Earnings Ratio: A measure of how much the company stocks up components and supplies etc before completing packaging and shipping to customer 
  
  

Stock Trading Part Four Quiz:

1. High Earnings Growth can lead to amazing stock trading returns provided?
   a. The stock market is going up
   b. The Price Earnings Ratio stays the same as rapid earning growth occurs.
   c. The stock has a low price to book ratio 
2. A investor buys a stock at the beginning of the year for a price of $20.00 per share. The earnings grow at 100% and the PE ratio is the same at the end of the year as the beginning of the year. What is the stock price at the end of the one year period ?
   a. $20.00
   b. $30.00 
   c. $40.00 
3. An investor buys a stock at the beginning of the year for a price of $80.00 per share ? The earnings grow at 200% and the PE ratio stays the same at the end of the year as the beginning of the year. What is the stock price at the end of the one year period?
   a.  $80.00
   b. $160.00
   c. $240.00.

Answers to Stock Trading Part Three Quiz, 1.c, 2.a, 3.a

Answers for Price Earnings Ratio: Stock Trading Part Four found in Stock Trading Part Five

Stock Trading Part Five: Click here to continue with Part 5 a full circle view of Dell Computer amazing stock run

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