One of my favorite topics to write about is portfolio management.  That’s because I love my methods for managing equities and bonds.  The methods work, but they aren’t a lot of work.  So, I enjoyed writing my piece last night, Earnings Estimates as a Control Mechanism, Flawed as they are.  And I got two good comments that I would like to develop here.  Here’s the first comment:

Actually, David, I think you have left out the more pressing issue with earnings estimates.

The system, such as it is, has evolved as a collaboration between the companies and analysts to promulgate estimates that are deliberately LOWER than is realistic. Both parties know that stock prices do well when they beat estimates, and it is a lot easier to set the bar really low than to actually outperform realistic expectations. I think many small investors don’t realize how the analysts are linked at the hip to the companies they supposedly cover objectively—when the stocks do well, the analysts do well!

This of course is the data shows that 60-70% of companies beat estimates every quarter, even in lousy years, and why you see stocks almost always beat the bottom line estimates even when they fall short of revenue estimates.

Just another way in which the integrity of the markets is in an utter shambles.

I appreciate what you have to say, but it is not something that I did not consider.  I omitted it for reasons of brevity, and I will explain why here.  If management team lowballs earnings estimates, they raise their forward P/E, which is a drag on their stock price.  There is no free lunch here; stock prices converge on the market’s view of future earnings power.  A management team can set their estimate of future earnings wherever they like.  A high estimate may goose stock prices in the short run, and low estimates may cause stock prices to fall in the short run.  But in the intermediate term, actual earnings will mean more to stock prices than any games played with earnings estimates.  Managements that cheat eventually get punished.

Here is the second comment:

A comment that reinforces the caveats on forward earnings: Lombard Odier has shown that there is NO correlation between forward P/E and actual returns over the following 12 months (http://media.ft.com/cms/965cca10-b5d7-11df-a65e-00144feabdc0.pdf).

And a question. All measures like the growth in tangible book value per share become considerably more complicated to evaluate when a company grows via a series of mergers. In theory one can do the analysis on each tributary. In practice, getting to know the peculiarities of the accounting in each company involved becomes very time consuming. I wonder how you approach such a case?

On the forward earnings piece, that may apply to the market as a whole but that may not work with individual stocks.

On your question: yes, when we are dealing with M&A the calculations become more complex.  Using the measure of tangible book value per share penalizes acquisitive companies, unless they can buy companies for less than their tangible book value per share.  There are other issues, in that one must give companies credit for spinoffs and such.  I covered that my piece Cram and Jam.  The main question that investors should be asking is: are management teams growing net worth per share for investors on a fair market value basis?

Many do not do that.  Instead, they choose a shortcut.  The most common shortcut is maximizing operating earnings per share.  That measure does not take to account the losses that occur from one-time events and chicanery that comes from buying back stock at prices that are too high.

One more note: I usually avoid companies that do a lot of acquisitions relative to their size, because they tend to underperform.

Final comment

I appreciate all the blogs that quoted my piece yesterday, or linked to it.  But there is a misunderstanding.  Though I am not crazy about sell side earnings estimates, I still see them as necessary.  Why?  We need them to allow us to evaluate progress of the company quarter by quarter.  To use a gambling term, earnings estimates are “the line.”

We could argue that we don’t need to evaluate companies quarter to quarter, and I’m fine with that.  Let’s be like Buffett and say that we would be happy if the stock market were closed most of the time.  I could live with that, but most players the stock market could not.  So, if we’re going to allow the market to be open every day, then we need a control function to allow us to estimate the change in value of a corporation when its earnings are released.

Earnings estimates are a necessary evil.  Please remember that as the earnings season begins.

Why does the stock market pay so much attention to earnings estimates?  Don’t earnings estimates embody the worst type of analysis of stocks on Wall Street?

There is some truth to the thought above.  After all, earnings estimates eliminate all one-time charges.  Now, that makes sense in the short run, but not in the long run.  In the short run we want to estimate the growth in value of the business on a continuing basis.  Thus, we eliminate one-time events.  In the long run we must see how a management team has grown the total value of the Corporation.  To do that, we must factor in all of the one-time events as well as the regular earnings in order to see how they have managed Corporation over time.  Would that one-time events were really one-time events.  And, would that one-time events averaged out to zero.  But truth, one-time events are on average highly negative.  And so, companies with a lot of one-time events typically have lousy earnings quality, and deserve a lower price earnings multiple as a result.

So if there is that much trouble with how we measure earnings as far as earnings estimates go, why do we use earnings estimates?  Most of the value of a Corporation on a going concern basis stems from the future earnings of the company.  Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate.

Now, it wouldn’t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof.  The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not.

So long as the earnings estimates are relied on a fair measure of likely future earnings of the company, they become an influence on the current price stock.  For example:

• If earnings estimates rise rapidly, so will stock prices.
• If actual earnings comes in above estimates the stock price will have one-time rise.
• And vice versa for when estimates fall , and when actual earnings are less than the estimate.

Now if earnings estimates were done right, together with growth estimates, by angels did not men, they would serve as cornerstones for estimating the value of corporations.  But our ability to see the future even collectively is poor.  Many things happen that we do not expect, whether from the government or the central bank or wars, you name it.

But even with all those flaws, earnings estimates provided useful function in being a feedback mechanism so that the market knows how to react in general, when earnings are released.

New Problem

But when beating earnings estimates become the be all and end all of the corporate management, we run into trouble.  Knowing that the estimate drives the stock price, makes some corporations fuddle the accounting.  They adjust revenue recognition, they differ recognition of expenses, enter into useless mergers and acquisitions, etc. Most accounting chicanery problems would not exist if beating the earnings estimates was not so important.

So what do we as investors do?  We look at the release of actual earnings with skepticism.  We carefully consider the adjustment of net earnings to operating earnings and asked whether the adjustments are truly reasonable or not.  We also don’t give full credibility to earnings estimates as if they were a sure thing.  Further, we review revenue recognition policies, and all other means to easily adjust operating earnings so we are not deceived by corporate managements.

And, if I can be so radical, we begin ignoring earnings and focus on growth tangible book value per share.  We look at growth cash flow per share net of maintenance capital expenditure.  We do all we can estimate free cash flow, and yet, take a step back and ask how the free cash flow is being used.

Free cash flow is not valuable if it’s being used to buy back stock at a high multiple.  It’s not valuable if it’s being used to do a scale acquisition.  Both of these are forms of dilution to common shareholders.

The key question is this: is the management building the net worth per share of the company?  That’s a lot harder question asking if the current earnings beat the estimate, but if this were easy, they would’ve brought someone else in to do it, not you or me.

PS – I leave aside the issue of intangibles here.  Usually intangibles are worthless.  But some are quite valuable, like the name Coca-Cola, or distribution network that is not easily replicated, or research and development is unique to the Corporation has not yet developed into a product.  All that said, for an intangible to have value, it must produce additional cash flow in the cash flow statement under operations, that do not reflect in the earnings statement.