The market is priced on expectations of the future. It doesn’t matter how profitable a company may be today. What matters for its stock prices is what it will make in the future.
Those who are new to the stock market often don’t know this. They think a growing or profitable company always makes for a good stock. But growing profits are already reflected in the price of a stock. To outperform, you need to find stocks that will grow at a higher rate than the market expects.
Take Apple (AAPL)… It’s one of the most profitable companies in the world – second only to Berkshire Hathaway (NYSE: BRK.B) by net income. But that’s no secret. Everyone knows Apple makes gobs of money.
This month, Apple CEO Tim Cook announced that iPhone sales would fall short of expectations.
This doesn’t mean Apple is losing money. Far from it… the company will earn something like $60 billion in free cash flow (“FCF”) – the purest measure of profits. It will pay the same dividends and buy back the same number of shares as it has in past years.
Even so, shares shed about $50 billion worth of value after the announcement (and $430 billion since the market downturn started in October). All because the outlook for future earnings have dropped a bit. Analyst consensus estimates for 2019 revenue have declined from $276 billion to $259 billion. Earnings per share fell from $13.20 to $12.
In a sense, nothing has changed about Apple. But sentiment has changed. The collective feelings of market participants have assigned Apple a different price. In September, investors would pay about 20 times current earnings for the future of Apple. Today, they’ll only pay 12.5 times earnings.
It’s the same with stocks in general. As measured by the S&P 500, they’ve reduced their price from 21.1 times earnings to 17.3 times earnings.
The price of stocks is a pure measure of investor senti- ment. It distills every idea every investor has into one single number.Dr. David Eifrig