Darkness Falls at Knight/Trimark (News) October 11, 1999

Darkness Falls at Knight/Trimark

By Brian Graney (TMF Panic)
October 11, 1999

Market maker Knight/Trimark Group (Nasdaq: NITE) woke up to a bad hangover today, shedding about 12% of its share price after warning that its third quarter earnings per share will come in lower than expected at $0.17 to $0.19.

The company's shares have lost traction recently as observers took turns speculating how lower trading volumes in the company's bread-and-butter markets during the summer months would impact the firm's earnings picture. Wall Street analysts had ratcheted down expectations, but they obviously didn't go far enough. The First Call mean EPS estimate before the warning was $0.30, down from $0.37 in mid-September and $0.42 in mid-August but still suggesting a heady 130% year-over-year growth rate.

With the new guidance in hand, Knight/Trimark is set to report year-over-year earnings growth between 31% and 46% and revenue growth of 49% in what was by all accounts an absolutely crummy quarter for e-brokers and market makers alike. Those growth rates appear pretty lame when stacked up against the triple-digit advances the company sported in the first two quarters of the year. Then again, any mature business in its right mind would kill for that kind of "weak" growth in today's earnings growth rate-obsessed investing environment.

The problem, of course, is that Knight/Trimark is anything but a mature business. The rampant growth of the online brokerage industry coupled with an unabating investor enthusiasm for stocks have driven demand for the company's trade executing services through the roof. The stock price naturally followed suit, until the trading slowdown this summer took some of the wind out of the company's billowing sails.

Valuing a company in hypergrowth is not the easiest thing in the world to do. In the end, many investors end up falling on one side or the other of the "too rosy" or "too pessimistic" expectations divide. Individual investors shouldn't beat themselves up too much about their failings in this area -- many professionally paid analysts whose job is to figure these things out can't do it either. Knight/Trimark offers a stellar example of this phenomenon: Sell-side analysts covering the stock were basing their opinions on a single-shot valuation approach that more often than not relied on the all-too-common bedfellows of earnings multiples and expected growth rates.

Relating the price-to-earnings ratio to expected growth rates (or PEG analysis) has its benefits, but it loses a good deal of its utility when used to value a company like Knight/Trimark, where the main EPS growth variable is anything but known even one quarter down the road. Stressing the company's "unique position in the eBrokerage industry" and using that unquantifiable attribute to justify that the share price should trade at a 50% to 100% premium to the multiple of the entire U.S. stock market -- as one sell sider did recently -- just ain't gonna cut it.

Eventually, the issue of valuation goes back to projecting future cash flows. With this in mind, investors interested in trying to figure the appropriate value to place on a company like this should focus on the main value drivers and how the overall business model lends itself to improved value creation over time. When the company's earnings report comes out and the situation can be more thoroughly analyzed, investors should spend their time thinking about how Knight/Trimark can leverage its low-cost, large-scale position in the market making business to higher returns over time, rather than pondering whether the company can hit a certain analyst's often shaky short-term assumptions.

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