Knowledgeable investors recognize that there are basic stock market principles. The first and most fundamental principle is that a company’s stock price ultimately follows that company’s earnings. However, in the short term, stock prices and earnings are less correlated. Prices frequently reflect emotions, as investors continually react to company news, market fluctuations and reports on the economy.
Check Capital has created graphs which illustrate how the stock market works. For each of our holdings, we present two graphs revealing company performance over a period usually more than 20 years.
The top graph shows stock prices and earnings per share. A decade on this graph is often long enough for you to see the close relationship between company earnings and stock appreciation.
The bottom graph plots stock price divided by earnings, a ratio known as the “P/E”. Note how dramatically the P/E for a particular stock varies over time. Obviously, all other things being equal, it is advisable to invest in a stock when it trades at a relatively undervalued level. Since the stock price and earnings lines track each other over time, when you find a significant gap between these two lines, the stock price is likely undervalued or overvalued.
In addition to the graphs, you will find fundamental data for each company. This data, combined with current news and valuation information, allows you to remain a truly informed investor, one who appreciates how a longer-term perspective increases the odds of long-term success.