When Crystal Balls Crack

Wouldn't it be great to know the future? To know precisely how much money a company is going to be able to earn over time before you decide whether to invest in it? (No need to answer. This is what we call a rhetorical question.)

Individual investors have a number of tools at their disposal when poking and prodding companies to test their investment potential. One tool that we use regularly at Motley Fool Hidden Gems to gauge a company's valuation is the "run rate," applied variously to a company's earnings or free cash flow. It's an elementary math equation that, really, your average 10-year-old could master, but it's useful nonetheless for "telescoping" earnings over a portion of a year through year-end.

An earnings telescope...
We generally use run rate when updating Hidden Gems members on the progress of our recommendations. We look at how a company has performed in its fortunes and its failings over the year to date and then annualize that performance to "guesstimate" what kind of numbers the company will put forth at the end of the year. For example, if a business has reported earnings for its first and second quarters only, but we want to know how much it will make through the end of the year, we can hypothesize: "OK, if Company A earned X in the first six months of the year, then over the full year it should make roughly X times 2."

Think of the run rate as a telescope for peering into a company's future -- but not too far into the future, mind you. The run rate doesn't, after all, take into account a company's ability to grow earnings over time. So you wouldn't want to multiply X times 20 and assume that in 10 years, your company will earn 20X. As telescopes go, this one's a Wal-Mart (NYSE: WMT  ) special as opposed to a Hubble. It can show you the moon, but you'll need a more complicated apparatus to get a good view of Alpha Canis Majoris (the star that gave Sirius Satellite (Nasdaq: SIRI  ) its name).

...With a smudged lens
So, nearsightedness is one drawback that comes as a standard feature on the run rate telescope. But that's just the obvious one. To use run rates effectively, you need to also understand that in some cases, this tool has a blind spot rendering it inaccurate even at short distances. That blind spot has a name: the seasonal business.

We're talking particularly about businesses that make most of their money in the second half, or even the fourth quarter, of a calendar year. Retailers such as Circuit City (NYSE: CC  ) and Toys "R" Us (NYSE: TOY  ) , both of which get a lot of business around Christmas, have their sales and profits heavily weighted toward the fourth quarter of the calendar year. Toy maker Hasbro (NYSE: HAS  ) , which supplies retailers with goods in the months prior to Christmas, also makes most of its moola in the second half. (The same would go for Santa's elves if they didn't work for a nonprofit.) In short, Q4 is hugely important to the nation's retailers.

Walk, don't run rate
What this means for investors is simply this: When you use a run rate to project a seasonal business's results for calendar Qs 1-3 into Q4, you're guaranteed to underestimate the likely annual sales and profits. Take a look at the cash flow statement for Sears (NYSE: S  ) , and you'll see the proof in this Christmas pudding. The cash generated in the quarters ending in April, July, and September of last year, times 1.33, did not come close to the amount of cash generated in the quarter ending on Jan. 3, 2004. In fact, Qs 1-3 resulted in negative cash generation, while Q4 proved quite positive.

So the moral of the story is this: When crossing earnings street, don't "run" to conclusions. Look both ways, then walk cautiously. Look first at the company for which you want to calculate a run rate. Is it in a seasonal business? If it grows crops, sells toys, or finances mortgages, chances are the company's business varies with the season. On the other hand, if it processes paychecks or builds B-2 bombers, its fortunes should change less often than the weather.

Next, if your company turns out to have a seasonal business, you need to examine when its fiscal year begins and ends. A seasonal business with a fiscal year tracking the calendar year is going to be really tough to calculate a run rate for. Because whether you've got data on just Q1, on the whole first half of the year, or on the first nine months, chances are you cannot accurately telescope that data out to cover the full year's results. On the other hand, you may find that your company's fiscal year begins mid-year. Archer Daniels Midland, for example, starts up its fiscal year smartly on July 1. Cisco Systems (Nasdaq: CSCO  ) starts even later, on Aug. 1.

Of course, even mid-year starters can pose a problem -- when you've got data on a fiscal first half that falls in the second half of the calendar year, for example. If the business makes most of its money in the second calendar half/first fiscal half, then a run rate extrapolating the fiscal first half's profits into a traditionally lean fiscal second half could cause you to overestimate the company's earnings.

Long story short, you may be better off eschewing run rates altogether when evaluating a seasonal business. Just value the company based on its trailing 12 months (TTM) results -- which incidentally are provided for you right up front on most financial information websites -- and call it a day.

Does all this talk of fiscal and calendar timelines make your eyes cross and head hurt? Never fear. Take a free trial ofMotley Fool Hidden Gems, and we'll not only keep our eyes on the ball and interpret the numbers for you, we'll explain what we do and why we do it every step of the way. In no time at all, you'll be investing like a natural -- and having fun doing it. It's all part of The Motley Fool's grand plan for worldwide domination and customer elation: To "educate, amuse, and enrich."

Fool contributorRich Smithowns shares of Hasbro. The Motley Fool is investors writing for investors.


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