In this edition of Investing chronicles, Lockstep CEO Paul Farah analyses the correlation between earnings and share price using real-world examples, discovering what truly matters for long-term investment success.

There is a 100% correlation between what happens to a company’s earnings 

over several years and what happens to the stock (price)."
Peter Lynch

The above statement comes from a 1993 interview with Charlie Rose, which we discussed last week in How to value a business based on future earnings.

In essence, Lynch says that if a company’s earnings perform well over a sustained period, its share price will do so, regardless of market and political noise.

That is a bold statement!

If true, it simplifies our approach as investors because it means all we have to focus on is the company and its fundamentals, leaving aside short-term share price performance and economic and market commentary.

But is this true? Let’s explore.

The correlation between earnings and a company’s share price

What is correlation?
Correlation simply means there is a relationship between two or more variables. For example, egg prices are correlated with the supply of eggs – if there is a shortage of eggs, prices will increase.

How to measure the correlation
Correlation is measured on a scale from -1.0 to 1.0:

• A correlation of 1 implies a perfect positive correlation, meaning both variables move perfectly together.
• A correlation of -1 implies a perfect negative correlation, meaning as one variable moves up, the other moves down.
• A correlation of 0 means there is no relationship between the two variables.

In our case, we are looking for a strong positive correlation. Anything above 0.9 is considered exceptionally strong.

You don’t need to worry about the mathematics behind it; I’ll do the calculations for you!

Correlation in our investing
Our goal is to see if there is a correlation between earnings and share prices. If a company’s earnings increase, does the share price also increase?

We’ll examine a company’s revenue, operating income (or Earnings Before Interest and Tax, EBIT), and net income growth vs. the share price and account for dividends, as they reduce the share price by the same amount.

Microsoft case study

Let’s start with the largest company by market cap in the S&P 500, Microsoft (MSFT). We will look at the company’s revenue per share, operating income per share, and net income per share from 2000 to 2023 and compare the growth to the company’s share price over the same period using the closing share price for its financial year-end.

As you can see from the graph, revenue, operating income (EBIT), and net income have all increased significantly from 2000 to 2023, while the share price has also increased, although it lagged slightly. This lag is expected as earnings are not released immediately, so the share price needs time to respond.

More importantly, the correlation coefficients are as follows:

• Revenue: 0.93
• Operating income: 0.96
• Net income: 0.96

Any correlation above 0.9 is incredibly strong, indicating that as Microsoft’s earnings increase, its share price follows almost perfectly.

Broader analysis

We need more than one sample for a good study.

Here are the correlations for the top 6 stocks in the S&P 500:

All companies show a very high correlation between earnings metrics and share price.

This suggests that focusing on a company’s fundamentals is vital for long-term investment success. Most interestingly, operating income, on average, correlates with the share price the most, meaning it should be our main concern.

Conclusion

Peter Lynch was onto something when he emphasised focusing on a company’s earnings.

Investors should concentrate on the company’s economic growth rather than short-term market fluctuations, the broader economy or political landscapes. A company growing its revenue and maintaining high operating margins will likely see its share price follow.

If the share price doesn’t appreciate, it may indicate a buying opportunity, as the market may be missing out on an excellent investment.

There’s plenty more to discover with Lockstep. 
Head over to Lockstep to subscribe to Paul Farah’s weekly investing newsletter. It’s never been easier to gain valuable insights that you can apply to your investment journey and take your money game global.

DISCLAIMER
Paul Farah has worked in financial markets since 2006, holding positions at prestigious firms from New York to South Africa. Now, he manages his own money and provides access to his entire portfolio through his company Lockstep Investing. The views and opinions shared are his own and are for informational purposes only; they are not intended to serve as investment advice and do not represent the views or opinions of Standard Bank. This information should be used as a starting point for generating investment ideas and should not be relied upon as the sole basis for making investment decisions. Lockstep Investing (PTY) LTD and the Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.