These days you hear a lot of market commentators saying, "What we're seeing in the market now is that, once more, earnings matter." They say this either in a self-congratulatory tone -- whether or not they had decried the "madness" of 1999 in the first place -- or as they don sackcloth and shower themselves with ashes of remorse. "I said before that earnings don't matter. Now, with the help of my clergyman and some anti-psychotic medication, I realize my error. Earnings do, in fact, matter."
Ah, says the Consensus, a return to sanity. We're going back to the way things were before the Flood, when we knew what was right and what was wrong. Back in those days, a company that lost money wasn't worth a darn -- and we didn't fall for this "pro forma operating profit" stuff, either. We knew what price/earnings ratio was acceptable and what wasn't, and a company was valued accordingly.
Don't fall for it. All of the sorry straw people I've set up are wrong. Trying to value a young company by its present earnings is like trying to value a 14-year-old child by how much she makes from her paper route. In business, earnings may or may not matter, depending on what they say about the company's potential to produce strong future free cash flow.
All investors are looking for companies that are trading for less than they are worth. Their worth is the free cash flow that they will produce in the future, discounted to their present value. Discounting means figuring out how much a dollar earned 10 years from now is worth in today's dollars and factoring in the opportunity cost of not investing in something else. (You can factor in risk too, but that's another topic.)
Note that we are talking about future cash flows -- not present or past, but future. Investing is all about figuring out what future cash flows per share will be and discounting them to current value. It's the same for bonds, mature companies, and young companies. It just gets tougher to estimate as you move into more uncertain territory.
With certificates of deposit and government bonds, future cash flow is a simple matter, since the coupon tells you how much you'll get each year. With stocks, it's trickier. Their return comes at different rates and at different times, depending on the company.
Some companies produce highly dependable cash flow. You can pencil in a nice, solid increase for Johnson & Johnson (NYSE: JNJ) next year. Its operating cash flow has risen an average of 17.5% in each of the last nine years. Wrigley (NYSE: WWY), too, sees a constant, steady increase in operating cash flow over the years, and spending on capital equipment remains at a virtually constant level. With companies like these, investors can forecast cash flow fairly dependably.
With young companies that have no track record or current earnings, investors have a very difficult time forecasting cash flow. The result is that their prices gyrate up and down on news or momentum, as investors fumble blindly for the proper value like a drunkard swinging at a piï¿½ata.
That volatility doesn't mean the companies are valueless, however. On the contrary, there is a much better chance of finding stocks that the market has mispriced among these young companies than among the J&Js of the world. That's why the Rule Breaker Portfolio fishes in these waters. When doing so, though, it's necessary to focus on the true goal of investing: It isn't about the best technology or the biggest lifestyle improvement; it's about long-term free cash flow generation.
To that end, it's worth keeping a couple questions in mind:
1. Does the company have a competitive advantage? This will be the source of excess operational cash flow with incremental investment. It's easy to recognize the competitive advantage of J&J or Wrigley -- it's in their brand names and the perpetual demand for their products. For that reason, cash flow remains dependable. With new products from young companies, it's harder to recognize the strength of brand or the extent and duration of demand. For that reason, it's generally possible to buy such companies below their discounted cash flow value when they're young -- if you can spot them.
In recent years, investors thought they saw competitive advantages all over the place. WebVan (Nasdaq: WBVN) said that it would take grocery orders -- get this -- over the Internet, and immediately received a valuation just a little below Kroger (NYSE: KR). Turns out that the method of ordering groceries doesn't change the fact that grocery delivery is a crappy business that increases costs with each customer added.
For more about competitive advantage periods, take a tour of Michael Mauboussin's CAP@Columbia site.
2. How much future investment will the company need? This is tied to competitive advantage, where growth comes with smaller incremental investment. Capital expenditures diminish cash flow. One of the reasons that Internet and biotechnology businesses found such acceptance on Wall Street (and in our portfolio) was that they had the promise of minimal future spending needs.
Take Human Genome Sciences (Nasdaq: HGSI). It spends a lot of money up front to develop a drug, but once it's on the market, the cash flows in for years like an annuity with little cost. Amazon.com (Nasdaq: AMZN), too, has the potential for similar returns on investment. It paid up front to create a great site, a strong brand, and a distribution network. Now it can handle large increases in sales volume with hardly any capital spending. That gives it superior cash flow potential -- if it can start earning an operational profit.
On the flip side, I don't understand why investors dive into young companies that seem to have no end to capital spending requirements. Telecom companies building vast networks require so much investment on an ongoing basis that it seems impossible to imagine payoff potential. Then there are concept companies like Ballard Power Systems (Nasdaq: BLDP), which has spent 25 years building a viable automotive fuel cell. Even if its product does catch on, Ballard will continue to require huge capital expenditures on factories and equipment. It's a freaking auto part manufacturer, after all. This is not an industry noted for its low capital requirements and high return on investment.
Something to avoid
As a bonus, here's a question NOT to base an investment in a young company upon:
Does the company have a large addressable market? You want a company to have a large addressable market, sure, but that's not enough. Companies without a competitive advantage won't be able to create cash flow without boosting costs, too. Most products that have broad appeal will quickly become commodities, meaning little pricing power and lots of competitors soaking up demand.
If you want my opinion, the lesson we should be taking away from the recent bubble is that a desirable product does not a good investment make. Investors saw a lot of products with broad appeal -- fast Internet connections or home grocery delivery, for example -- and figured that the companies that provided them must be good investments. That is not necessarily true; in fact, it's wrong more often than it's right.
So don't fall for the old "if we can just get 1% of the Chinese market" arguments. If the company has no competitive advantage, it won't beat its cost of capital.
If you're dealing with established companies, you might be able to learn something from earnings -- though you'd be much better advised to focus on free cash flow. If you're going to invest in riskier, young companies, present earnings mean little. Make sure, though, that you ask the right questions about the future.
Want to learn more about how to assess companies? Get started with your own research with our Evaluating Companies for Investment seminar. Hey, if you're not happy with it, we'll give you your money back!
Brian Lund absolutely hates it when bicyclists zoom through stop signs. The only thing he hates more is when he gets caught doing the same in his car. He does not own any of the stocks mentioned in this article. The Motley Fool is investors writing for investors.