The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

MP = EPS X PE

11/15/2016

The Market Price (MP) of a stock is equal to Earnings-Per-Share (EPS) times the Price-Earnings (PE) ratio.

Conservative pundit and serious Supply-sider Larry Kudlow is fond of saying that “corporate earnings is the Mother’s milk of stock prices.”  As corporate earnings increase, market prices should logically increase.  (EPS is nothing more than the corporate earnings divided by the number of shares of stock.)

A year and a half ago, corporate earnings stopped growing.  During the third quarter of this year, earnings finally started growing again, at a respectable 2.9% pace.  Analysts now predict 3.5% increased earnings in this quarter, followed by a whopping 11.4% and 10.5% in the first and second quarter of next year.

So, we should expect stock prices to rise, right?  Don’t forget you have to multiply EPS times the PE to get the market price.  If a firm’s earnings-per-share is $1, and I’m willing to pay 20 times the annual earnings of $1 per share, the market price of the stock is $20.  ($1 X 20 PE)  This is where investor confidence and sentiment influence the market price.  In recent years, investors have been willing to pay 18-20 times the EPS.  Of course, in times of economic fear, the PE may fall, pulling down market prices, even with rising earnings.  This is not one of those times.  We have rising earnings and rising optimism, which is the recipe for a bull market.

I think the election of Trump will increase the PE, as the “sugar-surge” of a robust fiscal policy (read: deficit spending) spreads across Wall Street, lasting at least until Springtime.  With complete control of government, the gridlock over fiscal policy (taxes and spending) will finally be broken, lending some badly-needed assistance to an over-worked monetary policy.

Party on, Garth . . .

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