Earnings Cast a Shadow

Read the financial pages and you'd think earnings and earnings growth tell you everything you need to know about valuing stocks. This isn't true, and the sooner investors know that the market knows it, the better off they'll be.

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By Richard McCaffery (TMF Gibson)
December 21, 2000

In the hunt to find stocks likely to produce strong returns, many investors lean heavily on historical and projected earnings growth.

And why not, especially when we read lines like this in pricey financial textbooks: "...the ultimate determinants of stock prices are expected corporate earnings and interest rates (which serves as a proxy for investors' required rate of return)... In other words, investors must be concerned with earnings and interest rates as they assess the outlook for stocks."

So break out your Value Line Survey and hunt for steady earnings growth rates, right?

This is a dangerous assumption, more so because it makes investing sound so easy: Investors can't control interest rates, so just concentrate on earnings growth, a number anyone can crunch after pulling a few financial statements. If that was all investors needed to make money, wouldn't we know it by now?

Yet the market doesn't pay as much attention to earnings when it comes to valuing stocks as you might think -- and this isn't anything new. Check out this line from a 1974 editorial in The Wall Street Journal: "A lot of executives apparently believe that if they can figure out a way to boost reported earnings, their stock prices will go up even if the higher earnings do not represent any underlying economic change. In other words, the executives think they are smart and the market is dumb...."

Like Plato's allegory of the cave dwellers who confused shadows on the wall with real life, investors who believe that earnings and earnings growth drive stock prices will be disappointed. Worse, anyone who's ever stepped out of the cave sees that the cave dwellers haven't experienced the texture of the real world, where stock prices are affected by industry and market factors, the cost of a company's capital, the return generated on that capital, expectations of future growth, risk, rival investment opportunities, etc.

All these factors combine to filter the way the market views a given stock, a view that's often quite different from the earnings picture.

Look at casual dining restaurant Applebee's (Nasdaq: APPB), a chain of about 1,200 neighborhood bars and grills in the U.S. and abroad. Over the last five years, earnings at this solid company jumped to an estimated $2.40 per share in 2000 from $0.99 in 1995, representing 19% average annual growth. Value Line estimates Applebee's earnings will grow 15% annually long term.

Now, these aren't the kinds of numbers Cisco (Nasdaq: CSCO) puts on the scoreboard, and Applebee's pasta dishes aren't as racy as routers, hubs, and LAN equipment, but Applebee's earnings growth is nothing to send back to the kitchen. Last year Applebee's generated nearly $50 million in free cash flow on sales of $670 million. In other words, it generated close to as much in free cash flow as it reported on the bottom line, a nice indicator of its ability to produce cash.

With a low interest rate environment over the last five years and more Americans eating out than ever before, you'd think Applebee's shareholders would have plenty to cheer about, yet the shares have been in the same trading range, give or take a few dollars, since 1996. Average the high and low share prices for 1996 and 2000 and you get about $26 and $30 per share, which translates into an average annual return of less than 3% for the investor who held for five years. That's pretty sad, especially when you could have had your money in an index fund and earned a much higher return with lower risk.

So what happened? For starters, the company's capital structure changed dramatically in 1998, when long-term debt jumped to $146 million from $24 million a year earlier. Applebee's long-term debt as a percent of equity jumped from 8.3% to nearly 50%. The company borrowed the money, in part, to fund the acquisition of 33 restaurants in Virginia. 

Beneath this, however, were issues related to economic growth. Although the company's top line had been growing as a result of expansion, 1998 was a tough year for Applebee's in other ways. Comparable store sales at company stores, for example, slipped 0.4% that year, after managing just a 0.1% increase in 1997. (Comps improved 4.4% in 1999.) Expansion continued to fuel top- and bottom-line growth but investors were worried about low comps, an important indicator of overall franchise health.

It's clear the market responded to serious issues the company faced rather than simply earnings per share reported on the income statement.

The point isn't to pick on Applebee's, a company with a growth trajectory that's typical for many successful restaurant chains. The point is that earnings growth is only relevant when it's a proxy for actual growth in cash flows and the growth is sustainable. Beyond this, the market is looking for companies that generate a return on investment above the cost of capital. This is a measure of actual economic profitability. 

Most investors could reason from their own experience that earnings can't explain stock valuations. The average investor understands, for example, that all growth isn't good growth, that growth comes at a cost and that if the cost is too high then value is being destroyed. Investors also understand that net income, the earnings figure known as the bottom line, often is a pretty poor measure of profitability because of accounting estimates, shenanigans, and the fact that net income doesn't take into account changes in working capital.

In his article Thoughts on Valuation (pdf file), Credit Suisse First Boston analyst Michael Mauboussin cites three problems with relying on P/E multiples for valuing stocks, which really tell us the danger of focusing on the income statement and the bottom line: P/E multiples don't tell us anything about the risk of an investment, they don't include capital needs, and they don't take into consideration the time value of money.

Understanding what drives valuation isn't easy, but knowing this, even if you can't crunch all the numbers right away, is better than standing in the shadows.

Have a great day.