Odd Lots - Everything You've Been Taught About How to Value a Stock Might Be Wrong

Episode Date: October 30, 2017

Investors are constantly poring over income statements from big companies to figure out whether they should buy or sell the business's stock. But should they bother? In this week's episode, Joe and Tracy talk to Feng Gu, a professor at SUNY Buffalo, and Baruch Lev, a professor at NYU's Stern School of Business, about why the way we account for a company's earnings might be massively outdated.See omnystudio.com/listener for privacy information.

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Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. And welcome to another episode of the All Thoughts podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. So, Joe, we are in the midst of yet another earning season, which means everyone is spending their time examining all the income statements that big companies are publishing, right?

Yeah, it comes four times a year, and it's one of the, you know, one of the most exciting times of the year, especially if you're a stock investor. because it's when, you know, the companies reveal all of the stuff that they did in the last quarter, their revenue, how much they made, how much their balance sheet, highlights of the quarter, and it's when you really have a chance to dig in because you have a fresh snapshot of the state of the company. Right, but there's a lot of work that goes into estimating earnings results even before they come out, right? Like analysts will be tweaking their models ahead of results season and then they'll be tweaking them after.

Everyone is sort of digging into the numbers to try to determine how well or how badly a company is doing. Absolutely. And one of the things that I think a lot of people don't get if they're not really active in markets is that there's no such thing is objectively good or bad earnings because in markets, everything is about relative to expectations. So you can have a company that doubled their earnings. and made a billion dollars this year versus a billion more than last year. But if the market was

expecting them to make $1.2 billion more than the stock might tumble, conversely, you can have companies that lose a ton of money, but if people were impressed by their revenue growth or people were impressed that they were expected to lose more, the stock might surge. And as such, it's the sort of like the classic Keynesian beauty contest. You don't just try to figure out what a company is going to earn. We also try to figure out what the crowd thinks the company is going to earn and how the actual results match up to expectations. Right. And some people say that things have gotten even more complicated in recent years because you have companies that sort of try to talk down expectations before their results. And so inevitably, they end up beating already low

forecasts. So there's lots of moving parts to this, isn't there? But Joe, what if I told you that digging into earnings is a useless exercise. If you told me that it was a useless exercise to dig in like this, I would be completely crushed because A, part of my job is to talk about this. And B, one of my first jobs was doing equity research for a small portfolio management company. And that's what I spent hours and hours going through every one of these lines. So please don't tell me, now I'm starting to get scared. Why are you hinting that maybe it's all a waste of time? Don't be scared, Joe. What I mean is it might be useless to dig into those earning statements in a sort of traditional sense. Basically, there are some people out there who think that the way we use current accounting rules or the way that accounting rules have been implemented doesn't really match the realities of our modern economy or our modern business environment.

Okay, so let's get to, I'm still sort of waiting for the buildup here. You'll be fine. You'll be fine. Okay, we're going to talk to Baruch Lev. He's professor of accounting and finance at Stern School of Business and Fangu, Associate Professor of Accounting at SUNY Buffalo. They put out a paper, which was fantastic on this exact subject, basically arguing that our accounting standards haven't really kept up with big, big changes. that have overtaken the economy in recent years. So let's get over to them. Baruch and Feng, welcome to the show. Thank you. Thank you. Thank you for having us.

So was that intro accurate? Is the sum of your work essentially that accounting methodology hasn't really adjusted to modern realities? I would say the intro is very accurate. It's not just that we claim that earnings don't matter. we actually prove it. In a recent article we published, we show for all companies that even if you had the dream forecasting machine, meaning that you could forecast, you could identify all the companies

that will meet or beat consensus analyst forecast next quarter, you're not going to make any money from this. You used to, in the past, big money. money, but no longer, and most people are not aware of the demise of earnings as an indicator of company performance, evaluator of managers' capabilities. So we actually prove it both in a recent book that we wrote and in the article. And this is really, I would say, earth-shattering, but it's a fact. This is indeed earthshedering.

I mean, in theory, this blows up the premise of so many of our conversations, which as we say, okay, Facebook earnings are coming out or GM earnings are coming out, and they're expected to earn a dollar and a penny per share, and they earn only 97 cents. And as you say, we try so hard to get this right. Let's say, maybe let's start from thinking. So where did the, if it's not right, where did it come from? Where did we get this idea of how we traditionally talk about earnings? The centrality of earnings comes from the work of Graham many years ago.

He was the celebrated teacher of Warren Buffett. And since then, earnings are the center of all the models that analysts are using. Everything is aimed at predicting forthcoming earnings. Managers are pastored to provide some guidance for forecasting earnings. Everything revolves around earnings. And there is, of course, a reason why so much money goes to index fund and to automated investment. Managed funds are not doing well. And we claim that the main reason why they are not doing well is because their focus on earnings is completely misplaced.

Right. And you have, like you said earlier, if someone built the perfect earnings prediction machine, there was a time when you could have made big money from that. and now it doesn't seem to be the case. So what exactly has happened there? What happened is that it used to be that earnings really indicated performance of companies. 30, 40 years ago, earnings basically indicated revenues minus real costs. Since then, there was a revolution in the business models of companies

from tangible to intangible assets. You don't make money anymore from... machines and equipment and building. You make money from patents and brands and information technologies and human resources. Everyone knows it. Everyone uses it, except for accountants that were really asleep at the wheel and still are. And all those huge expenses of companies in intangibles are expensed in the income statement, meaning they are charged against earnings.

So the earnings that you get today are completely misstated for some companies. They are overstated. For other companies, they are understated. Just think about the Amazon. In the last four or five years, they missed half their consensus earnings. Nothing happened to them. That's, of course, a marvelous company with a huge market value. Think about Tesla, incredible brand with a cumulative.

losses of one and a half billion dollars because they are forced to expense all their investments. A much smaller, less known company like Kite Farma, which works on very advanced cancer research, you look at the financial reports, accumulated losses of $600 million. They were just a week ago bought by Gilead Sciences for $12 billion. I mean, the financial reports completely misstates the picture of the company, the performance of the company, the future prospects of the company. And that's where we are now. And that's why that's the reason for the failure of the traditional analysis of companies

focusing on earnings. Again, these are not just claims that we make. In an article, we demonstrate that the loss of earnings relevance over time is really driven by companies that invest a lot of money in tangible assets. So over time, investors eventually realize that the earnings information, the profit loss and the balance sheet information investors look at is no longer relevant for evaluating the performance and value of these companies. So to be clear, just to clarify that a little further, there was a point in which that magic earnings Oracle would have made you a lot of money had you had it, and you demonstrate in your paper

that the value of that information in advance has declined. Can you talk us through a little bit the sort of the quantitative evidence you show that that isn't useful information anymore? Sure. Going back to the late 80s and early 90s, the gains from this dream machine of perfectly predicting future earnings would allow you to earn access profit in the magnitude of 25% each year. This is in access of market and risk-adjusted returns. So those were the good days of playing this earnings prediction game. Now, moving to the current time as off the end of 2015, the same process would earn you no more than 2% of access return. And there are, of course, a lot of treating strategies that can earn you even better access returns at a much lower cost.

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Before we get into, you know, obviously I want to talk about what we should be looking at instead of the traditional earnings. But before we get into that, it's still, you know, it makes me uncomfortable because even with all of the changes in business models and intangible assets, it still seems like an intuitive basis that the measure of a company is like, okay, but did you make money or not in this quarter? And how much money do you have today? and how much money do you have three months from now,

and that ultimately, for as weird and as different as business models get, profit is still the point of business. It sits it a little bit uneasy with me, that ultimately it still wouldn't come back to just how much money they made. You're right about the importance of how much money you're making now, and of course, even more important how much money you'll make in the future. what we claim is that earnings measured according to the accounting rules today don't even reflect this. That's why, for example, in our recent book, the end of accounting, we show that if you

base your analysis on cash flows, you'll be better off than if you'll do it on earnings. So you are perfectly right. It's, of course, of great importance how much money you make. but reported earnings don't measure how much money you make. By the way, managers know it, and that's the major reason why they release all those non-gap earnings, which are so derided by people. Some of them are, of course, a little massage, manipulated, but by and large, this is a managerial response to the inability of currently measured earnings.

to reflect what actually happens in corporations. Right. So it feels like every earnings season we get a news article about how reported gap figures are veering away from adjusted earnings. And lots of people have problems with adjusted earnings because they think they're vulnerable to manipulation either by managers or analysts might read too much into them. But you're arguing that they're a more accurate representation than traditional gap accounting, or that they fill a sort of gap left by gap, I guess. Again, it's not just my argument. It's the result of lots of research projects that are confirmed that investors react more strongly,

most forcefully to non-gap earnings than gap earnings. So investors find by and large non-gap earnings as much more informative than gap earnings. That's again a fact. These are things that are very easy to research and these are the findings. Feng, I think you mentioned Amazon or maybe we're talking about Amazon and Tesla. And of course, Amazon is sort of famous for people discarding their gap earnings or even their non-gap earnings. that you can have these quarters where they'll lose money and the stock shoots up, or they'll give a guidance range that's so wide as to be laughable, but it doesn't really matter to people and

people keep buying. The story that pundits like to tell about Amazon is that Jeff Bezos has done such a good job training Wall Street to not care about quarter to quarter profits that they can get away with huge investments and huge losses from time to time. But it sounds like what you guys are saying is that the way we characterize Amazon is a little too pat and that actually Wall Street's response is not about some training or anything like that, but essentially about investors just sort of understanding like in any company the numbers that really matter and that earnings aren't really it. Yes, that's absolutely true. So what we have advocated in a book as well the article is this notion of strategic assets. What really matters to a company's success

and competitive edge is not just current quarters earnings or profit. It's their strategic asset that give them long-term value in market competition. So for a company like Amazon, what investment has delivered to them is the growth of their strategic asset. If you think about their market share, their expansion into more and more market territories, that's the proof that they're growing their strategic assets very strongly. And the investors certainly understand this. At the end of the day, they're not just going to look at the quarterly profit or loss. Instead, they're going to pay a lot of attention to Amazon's strategic assets. How the assets have been investment, invested, deployed, and what kind of value has been created by these assets.

To interject a cautionary note here, we are speaking about Amazon and Tesla, and investors definitely understand these companies because they are led by extremely articulate and charismatic leaders and the message is clear, but there are thousands of companies out there without Jeff Bezos and other charismatic leaders that their message is not well understood and investors don't see the truth. They are still relying on the reported numbers which are misleading them. So that's why I think our message is so relevant today. If investors knew everything, we would even write this article now, but they are not. It's only for a few companies with those very effective CEOs or CFOs that can spread this message. The other thing I'm wondering is your findings,

you know, about this perfect earnings estimator and the fact that it wouldn't be much of an edge in the market nowadays. Does that say more about how the market is functioning than the deficiencies of the accounting rules themselves? Because one of the criticisms of the current market is that valuations no longer matter, you know, people aren't really investing on fundamental terms. They're just sort of following the money and it's all momentum based. You're right. They're not investing on fundamentals or less and fewer and fewer people are investing on fundamentals because it fails them. I mean, they see the results, after quarters and it's really not working. What we are saying is don't

abandon fundamental analysis. You still have very good information out there. You're focusing on the wrong information but you can shift and focus on the right information and you'll be much better off. Okay, well before we wrap up we have to talk about what these things are. So okay we mentioned that for example it makes sense to not hue too closely to traditional gap earnings. We also talked about the importance of having strategic assets, but for many companies that sounds like it would be something that is unquantitative or something fuel-based. Let's talk what are the things in an earnings report,

in anything else that we should really be focusing on instead to start building a mental model of what a company is worth. So I'll give you a couple of examples. If you are talking about pharmaceutical and biotech companies. You have a huge number of these companies. What they earned last quarter or last year is completely irrelevant to the future. What is relevant is what's called the product pipeline. The drugs, the instruments that they are developing, and all companies are providing very detailed information

page after page after page. It's not required by accounting rules, but they are doing it on the product pipeline. So if the company has products in advanced stage of development, phase two clinical tests, phase three clinical tests, they are close to the market, high likelihood that new products will come out of them. These companies are at a very good stage. I would invest in such a company.

I don't care about the earnings of such a company. Talk about my second example, internet companies, even insurance companies, media and entertainment, those main strategic assets are customers. Look at the main data, look at how many customers are being added every quarter, look at the churn rate, which most people are not aware of. Churn rate, meaning the percentage of customers,

they lose every quarter. That's what indicates the future, not the current earnings, last earnings, that they report. Basically, for every industry, you have those fundamental strategic asset that create value. For most companies, this information is given, and the focus should be on the performance of these assets, the potential of these assets. Just to play devil's advocate, though, you talk about companies with drugs in stage two

trials. But even then, to value that drug, don't you still have to come up with some model of how big the addressable market could be, how much profit that drug is going to? I mean, doesn't it still just come back to that being a tool to come up with some estimate of future earnings? Yes, you can do it. And actually, Feng and I developed such a model because there are quite reliable data on the likelihood of drugs in phase two getting to the market. and then you have the market size for the drug. So ultimately you can come up with a prediction of revenues from the drug, but the focus of analysis is not trying to predict just the revenues,

but looking at the fundamentals, what creates the value. In our test with this new methodology, we actually have seen evidence showing that this different way of evaluating pharmaceutical companies' fundamental actually produces information signals that lead change in their market value. In other words, we can actually see the change in the value of their product pipeline before investors actually realize things are becoming different. Well, I'm sure we could talk about accounting all day, but we have to leave it there.

That was Baruch, Lev, and Fangu. Thank you so much for joining us. Thank you. So, Joe, does that make you feel better or? worse about your previous career as a financial analyst? Well, I, you know, I'm no longer a financial analyst, so I guess it makes me feel good that I left that, you know, had I just stuck to trying to estimate EPS and all that stuff. But, no, in all seriousness, it is really interesting. I mean, one of the things I wonder is, like, to what extent do investors, you know, already sort of let

these other factors determine. I mean, the value of companies. It's not like all companies have the same PE ratio, the same forward PE ratio. To some extent, it's pretty clear that things like network effects or an internal company culture that allows it to produce great drugs, you would imagine is already being reflected in a lot of people's thinking about these companies. Right. And you do have some pretty big companies out there that are highly valued that haven't necessarily had that successful earnings quarters, I guess. I think what it comes down to for me, I think our guests, they've identified a problem which definitely exists. I think you can say that accounting rules for sure are not well equipped to deal with the realities of an economy

that's increasingly about research and development and, you know, brand value and information technology as opposed to, you know, machinery and manufacturing. I'm not sure about the solution because, again, it's one thing to say, oh, investors should consider the strategic assets of a company, but at some point you do want to see those strategic assets converted into some sort of revenue. Right. And that's sort of like, you know, it seems like in theory you should be able to square the circle and say, okay, it's great to have these strategic assets, but, you know, a strategic asset is only so good unless it produces revenue and income. But what I think is valuable here to me is like maybe there's still, it's like we have some

intuitive understanding that for all companies, whether it's an Amazon on one end, or whether it's a more standard industrial, like a Honeywell or a GE on another end, that there's this whole spectrum of business models. And we sort of have this intuitive understanding that, the sort of network effects or the customers or the attention of some companies matters a lot more for others. But maybe we still overrate the importance of a traditional earnings company for a traditional stock, even when it's not particularly appropriate and that we have to sort of adjust our dial to recognize that it's not the same thing looking at a sort of P&L statement

for a traditional industrial versus a P&L statement for an Amazon or a Facebook. Yeah, I think that's right. In any case, it's clearly a complicated topic, but something we can all keep in mind as earning season rolls on. And I'm very excited to read their book. I have it in front of me. The End of Accounting and the Path Forward for Investors and Managers by Baruch Lev and Fengu. So thanks to them for joining us. And maybe we'll, I'll read this and I'll get some more insight. All right. This has been another edition of the All right, I'm Tracy. Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthal, and you can follow me on Twitter at the stalwart. And we want to thank our producer, Sarah Patterson, who's on Twitter at Sarah Pat with two teas. Thanks for listening. I'm Francine Lacqua, an award-winning journalist, and I've got a new

podcast, leaders with Francine Lacqua from Bloomberg Podcasts. I've interviewed everyone from heads of state to fashion icons about the news of the moment. But I've always been curious, who are these people as leaders. I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision. Listen to new episodes every other Monday. Follow leaders with Francine Lacroix wherever you get your podcasts.