Home Investing Strategy Get Smart: Why We Back Businesses, Not Share Prices

Get Smart: Why We Back Businesses, Not Share Prices

We are closing in onto the end of the first quarter of 2021.

If you’re feeling queasy, I don’t blame you.

For the first half of the year thus far, the NASDAQ was racing to new highs. Then, at a drop of a shoe, the tech-heavy index reversed course and fell by over 10% from the year’s peak.

What followed was volatility, with stock prices swinging upwards and downwards at will.

For some investors, it’s been a roller coaster of emotions over the past few weeks, with euphoria one day and sadness in another.

If you’re feeling that way, you’re probably not the only one.

But you might want to stop looking at share prices.

Focusing on the business

When you invest, you are taking a part-ownership in a business.

It’s a straightforward concept.

And yet, most of the time, the vast majority of investors’ attention is pulled away from the business and lavished upon share prices instead.

It’s not hard to understand why.

When you invest, you are buying a stock at a certain price.

By doing so, your wealth becomes tied to the movement of that share price.

As such, as these prices move up or down, your invested cash climbs or shrinks in value accordingly.

And no one likes to see their hard-earned money disappear as the share price drops.

Two halves of the same coin

As hard as it is, there is a good reason why you should focus on the business rather than the stock price.

The two elements are connected.

A simple way to understand the relationship between the underlying business and its associated stock price is the diagram below.

The earnings per share represents the profit that the company makes divided by the total number of shares issued by the company.

In my eyes, a stock price is controlled by two main elements, the earnings per share (EPS) and the price-to-earnings ratio (P/E) ratio.

More importantly, both factors have an equal influence over the stock price.

Simply said, if the EPS were to go up and the P/E ratio stays where it is, the stock price will go up by a similar percentage as the EPS.

Likewise, if the EPS were to remain unchanged, and the P/E ratio increases, the stock price will increase at the same rate as the ratio.

But that is where the similarity ends.

The main drivers of your stock price

Companies have a fair amount of control over the EPS they generate, but not its P/E ratio.

By generating revenue and controlling its costs well, businesses can produce a profit.

In that way, the management team has a high degree of influence over what it earns, and by extension, its EPS.

On the other hand, the P/E ratio is a figure that is awarded by the stock market, akin to a proxy of investors’ enthusiasm for the company’s stock.

If sentiment is positive, the multiple can be bid up to higher levels.

Conversely, if pessimism sets in, the same ratio is lowered to a level reflecting the lack of confidence in the business.

Either way, businesses have little to no control over what P/E multiple is awarded.

Business growth outranks valuation

When your stock price increases, you want it to be backed by strong EPS growth.

If share price growth is driven by a higher P/E ratio alone, it may prove to be unsustainable over the long term.

As such, your eyes should be on the business and not the stock price.

Over the long term, EPS growth can make a huge difference to the stock price.

Take Apple (NASDAQ: AAPL), for instance.

My first ever purchase of the iPhone maker’s shares was made in June 2010 at a split-adjusted price of US$8.75 per share.

At the point of buying the shares, Apple had generated an EPS of US$0.32 for its past 12 months. If you do the math, the associated P/E ratio was around 27.5 times, as depicted below.

Fast forward to today and Apple has grown by leaps and bounds, driving its trailing 12 months (TTM) EPS to US$3.71. And if you applied today’s TTM EPS of US$3.71 to the price that I paid over 10 years ago (US$8.75), the corresponding P/E ratio would shrink to 2.4 times.

In effect, Apple’s TTM EPS soared by almost 12x over the past decade as smartphones proliferated across the globe.

Fittingly, at Apple’s share price of around US$121 today, the gains achieved are almost 14x, close to the rate of EPS growth over the past decade.

Get Smart: Your focus determines your investment reality

What you chose to focus on will determine your investment results.

If you choose to focus on the share price, you will be subject to the whims of the day-to-day stock market volatility, represented by the PE multiple.

There will be bouts of optimism and pessimism that can change at a drop of a shoe.

But if you can train your eyes on the business, turning your view away from the past and into the future, I submit that you will stand a better chance in scoring satisfying returns for your own efforts.

And that’s what we do at The Smart Investor.

Our focus has and always been about the business behind the stock ticker.

When share prices fall, we are looking at how the company is performing. Likewise, when share prices rise, our focus remains on whether these gains are fully justified.

That is why our aim at The Smart Investor is to demonstrate, through time frames measured by years, and not through a day-long investing course, that focusing on the business brings the kind of investing results that will make you proud.

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Disclaimer: Chin Hui Leong owns shares of Apple.