We all seem to have an unusual fascination with earnings. A company’s earnings, measured under specific accounting standards and tax laws, are arbitrary at best, whereas cash flow, like the balance in a checking account, is an actual number and subject to little interpretation. Earnings are opinion and cash is a fact.
BlackRock CEO Larry Fink’s recent letter to 500 chief executives, urging them for the first time to stop providing quarterly earnings estimates, is yet another plea for long-term value creation. Today, many companies are expected to execute corporate policies that reflect short-term earnings growth, thus forcing investors to rely mainly on what a stock is worth. When company forecasts are heavily based on earnings, one of the biggest problems is that they have been known to be overly optimistic.
Corporate shortsightedness is manifested by firms’ practice of providing short-term earnings guidance. However, firms that frequently issue quarterly earnings guidance also behave myopically. Further exacerbating this problem is the fact that managers are typically evaluated and compensated based on earnings goals, providing a perverse incentive to focus on producing short-term results. Moreover, if stock prices react to short-term earnings, managers can argue that they are doing their jobs in the name of “maximizing shareholders’ wealth.”
Since 2002, there has been a new movement led by the CEOs of top blue-chip companies such as GE, Microsoft, and Intel, to voluntarily stop providing earnings guidance. The intention was to relieve managers from being boxed into hitting short-term targets, and investors from being misguided. That being said, it is a reality that the public has most looked at short-term earnings in pricing their stocks. More than two thirds of stock price movements react to the quarterly earnings estimates. As a result, less than 15% of Wall Street analysts would even give cash flow estimates. However, whenever things take a turn for the worse, such as an economy going into a recession, stock market bubbles burst, and for those 25% of companies with negative fundamentals, the investors will resort back to quality; watching cash flow instead of quarterly earnings.
Arbitrary Simple Price Ratio Valuations
The easiest example of such a wide spread in using earnings in a quick valuation can be demonstrated by the wide spread use of the price (earnings) ratios in valuing stocks. We are often tempted to value a stock future price movement by simply comparing a stock’s current price ratio to that of its benchmark. An example for such practice is performed for nine of the most widely held tech stocks. The relative valuation for each stock is demonstrated by comparing its price ratios with the industry average in order to determine if each stock is fairly valued. Using this common practice, both earnings-based approach (PE) and cash flow-based approach (P/CF) reach the same conclusion that INTC, IBM, MSFT, and QCOM are undervalued while AMD, NVDA, and AMZN are overvalued. On the other hand, GE and FB are overvalued by future earnings, yet, undervalued by future cash flow (Table 1). Clearly, the simple index model is over-simplified. It is not forward looking, and it fails to incorporate the different risk level of each company/stock. A stock’s price ratio is supposed to be higher (lower) than the industry’s if the company has a lower (higher) risk. The fair value of a stock should reflect the forward-looking fundamental and adjusted for the corresponding risk level.
Using Earnings to Value Stocks
Especially for tech stocks, investors love to look at the future earnings rather than the cash flow dividend they will receive. For that reason and for the nine tech stocks we examine, the “Incremental P/E” approach can be used to identify mispricing of stocks based on the difference between the return on equity and the required rate of return. If the return on equity exceeds the rate of return that investors require given the investment’s risk characteristics, the company’s growth potential might be mispriced. The reasoning here is that the zero growth company should distribute all of its earnings to its investors. If the company is able to invest these earnings at a superior rate, at a greater rate than the required rate of return, it is going to add extra value to its shareholders. The Incremental P/E approach is trying to capture the company’s ability to reinvest its earnings at the superior rate.
Using Cash Flow to Value Stocks
Traditionally, the Street has been overly fascinated by the quarterly earnings growth rates. However, when earnings volatility becomes so extreme, say to triple digits, even the most die-hard fans of the company should realize it is not sustainable. When the most recent earnings growths are not expected to continue, shareholders should always come back to the basics, i.e., “discounting future free cash flow of the company.” Specifically, the long-term outlook on stock values may be looked upon based on the free cash flow to the equity holders. To them, the stock valuation is “the discounted value of future free cash flow.” As most tech firms invest heavily in capital expenditure of the next-generation technology that will produce exponentially high future cash flow, it is reasonable to assume a two-stage free cash flow growth pattern.
When to Use Earnings Vs. Cash Flow Valuation?
Given the often conflicting valuation conclusion from earnings and cash flow approach, the real question is, under what circumstances should cash flow valuation be used over earnings valuation? Although stock prices are on average, affected by short-term earnings, cash flow pricing is used primarily to price what we classify as “negative” stocks – stocks that are generally characterized as illiquid, mispriced, or having a shorter trading history, negative earnings, or negative market performance.