Earnings Are Overrated

In our society, we have a tendency to associate an item's worth with a single number. Houses are advertised by square feet, a burger by how much it weighs, a computer by how fast it is, and an SUV based on how many parking spaces it takes up (well, maybe someday at least).

But sometimes these numbers oversimplify our decisions and result in overlooking more subtle features. Is the half-pound burger better than the smaller, deluxe burger made from a leaner cut of meat? It depends on if you are taking more than just weight -- both the burger's and your own -- into consideration.

If there is one such overused number for stocks, it is quarterly earnings.

Doing the numbers
Investments of all kinds are traditionally valued by taking the cash flows they generate over time and discounting them to the present. For those who do not fully grasp the concept of discounting future cash flows, I suggest you sit down with my grandpa to talk about how much everything used to cost in the "good ol' days." The logic behind discounting is that a dollar today is worth more than a dollar in the future because the present-day dollar has the option of being invested and generating a rate of return over time. With this in mind, the value of a company can be simplified to taking its current earnings, applying a growth rate over time, and summing up all its discounted future cash flows.

So what is the problem with this approach?

From a mathematical perspective, earnings are much more volatile than other items on the income statement. Let's assume that a company has $100 million in revenues and $90 million dollars in expenses for a profit (earnings) of $10 million dollars. The following year revenues increase by 10% and costs remain the same. The earnings for this year would then be $110 million-$90 million = $20 million, or a 100% increase over the previous year's earnings.

In practice, revenues and expenses are usually correlated since revenues grow with increasing demand which is then met by the costs of producing more units, but the fact still remains that a slight twitch in the cost structure can have an enormous impact on the bottom line. Since current-day earnings are the starting point for many analysts' valuation models, a slight change can have a catastrophic effect on the stock as institutions flood in or pour out of the market.

Another reason earnings can be a poor indicator of a company's true worth is the fact that they represent the past rather than the future -- as was the case for AMD (NYSE: AMD  ) . As many of you probably know, AMD makes chips used in computers. The cost to make a chip does not vary greatly from one technology to the next, but the price for which a it can be sold varies drastically based on its standing in the market. A top-of-the-line chip can sell for over $700 while a low-end one may be priced at only $70. Since the cost to make these is very similar, it is clear which segment of the market is the most profitable.

Intel (Nasdaq: INTC  ) is AMD's biggest competitor and had long been the market leader with an exclusive grip on the "high end" market ever since it released the first Pentium processor. However, in June of 1999 AMD released its first Athlon processor, which took the performance lead over the Intel's then-current Pentium. If you were analyzing AMD at the start of 2000 based on recent earnings, you would notice that it had steadily increasing losses and had been a historical disappointment, and would not have invested in the stock. However, the Athlon immediately increased AMD's revenues and, based on the higher prices it commanded, led to record revenues in 2000. Since 2000 AMD has outperformed both Intel and the S&P 500.

Now a new trend has emerged with AMD's earnings. Since 2004 the company has been making money, and over the trailing twelve months earnings are up substantially. Analysts are more positive about the company now than they were in 2000. However, this summer Intel began releasing its next-generation Core processors. For the first time since the Athlon was released AMD is back to a point where its top-of-the-line processors are slower across the board. So is it time to buy AMD on strong earnings -- or sell based on the recent technological disadvantage?

That is the $64,000 question, and the ability to answer it separates good investors from the bad.

No formulas here
AMD's history illustrates how investors and analysts can get enamored with company earnings and miss the bigger picture. It is important to look at more than just earnings when making your investment decisions. Investing would be so much simpler if you could just plug a company's earnings into a simple formula and produce a more accurate value than the current market price.

But that's simply not the case. Being a successful investor involves looking beyond the numbers and deep into a company's business model.

For related reading:

Intel is aMotley Fool Inside Valuerecommendation. Take the newsletter for a free 30-day trial today.

Elliott Orsillo lives in Pasadena with his wife and his basset hound, Lola. When it comes to burgers he orders exclusively off the dollar menu. At the time of this writing, he holds no positions in any of the companies mentioned above. The Motley Fool has a disclosure policy.


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