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The statement above 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 is saying that if a company’s earnings perform well over a sustained period, its share price will do as well, 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 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 emphasized 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.

Innoviva Update

Last week, we looked at the investment case of Innoviva (INVA). If you missed it, you can read it here.

Yesterday, the company gave a presentation at the Goldman Sachs Healthcare Conference. The presentation provided valuable information, so I highly recommend listening if you follow the company.

Here are the highlights that stood out for me from the presentation:

Royalties Revenue

• The CEO of INVA expects these royalties to be stable and durable for “years and years.”

Xacduro

• Expected to be a significant revenue generator.

• Zai-lab expects sales of over $500 million per year in their territories. Innoviva will earn royalties from Zai-lab’s sales similar to its other royalty revenue streams.

Zoliflodacin

• There are 1 million cases annually in the US and over 80 million globally – “This is just a huge opportunity.”

• “It could be a $500 million per year product in the US alone.”

NOTE: INVA only earns revenue from sales in US and other developed markets for this product.

Other Insights

The analyst interviewing INVA’s CEO remains skeptical about the company’s ability to commercialize its antibiotic products, as many other companies have failed to do so.

This is both a risk to the company and a reason for the opportunity - If Innoviva fails, it will only have its royalty stream to fall back on. However, the market is currently discounting the products on the Innoviva platform. If Innoviva succeeds, it should perform very well.

Conclusion

Last week, I provided a rough UPSIDE calculation of around $32.40 per share versus the current price of around $15.94. Based on the additional information from the presentation, it is easy to see a well-over $40 per share upside.

Disclaimer: The content in this newsletter is provided for informational purposes only. It is essential to conduct your own research before making any investment decisions.

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