The Folly of Focusing on Earnings

 | Apr 23, 2014 | 2:00 PM EDT
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We are now deep in the heart of earnings season, and everyone is focusing on what the quarterly numbers will be for a number of companies. This is probably the silliest way to invest or trade, and I am pretty much convinced that this focus on short-term results is less than optimal for general business conditions.

I have to wonder if capital could be deployed more efficiently and intelligently if the managers of the business were not so focused on meeting or beating quarterly estimates. An enormous amount of money is used to fund stock buybacks for the purpose of massaging that number, and in most cases I would rather have the cash in the form of a dividend. The worst part about this focus on quarterly earnings is that reported earnings per share is probably the least important number in all of finance, in my opinion.

I have often said that I can analyze a company without ever looking at the income statement or even the cash-flow statement. Everything that happens in the operating of a business eventually shows up in the balance sheet. If you leave a competent accountant alone with the income statement long enough, he can make the numbers whatever you want them to be and still be within the confines of general principles and securities laws. It is a lot harder to do that on the balance sheet without telling outright lies.

Even growth-oriented investors should pay a lot more attention to the balance sheet than they do most of the time. If you want to know which companies are true growth stocks and have top-notch products, services and, more importantly, good management, look at the growth rate of the book value. A great manager is more concerned with growing the overall value of the business than with hitting some short-term guess about recent performance.

Companies that have grown book value at very high rates over the past five years include Apple (AAPL), Google (GOOG), MasterCard (MA) and Oracle (ORCL), all truly great growth stocks that have rewarded investors. Management has produced profits and reinvested them in the business in order to grow the value of the company and not just to hit earnings targets.

The flip side of this equation is that companies that are showing Wall Street pleasing earnings growth but are not growing the overall value of the company should probably be avoided by most investors. Management is not adding value, and the net worth of the business is being expended in order to make reported earnings. Often they have made poor acquisitions or added assets at high prices that subsequently had to be written down in value. Whatever the reason, net worth is not growing over time, and that is rarely in shareholders' best interests.

Some very interesting companies are on the list of suspect growers. Home Depot (HD) was lauded as a great buy in Barron's recently, and if you look at earnings growth over the past five years, it looks like a great story, as earnings have almost tripled. However, the overall value of the company as measured by book value has actually shrunk. It is even worse if you look back over 10 years, as total shareholders' equity has been halved from $24 billion to just $12 billion. All the billions spent on stock buybacks have not increased the per-share equity stake of shareholders by so much as a penny. The only thing that increased is the multiple of equity value that investors are willing to pay for the shares.

A look at some of the great growth stories from the perspective of book value growth shows that among Wall Street's favorite companies, some are not seeing the overall value of the company grow as fast as reported earnings. Everyone loves Time Warner (TWX), and the company shows stellar five-year earnings growth of 25% annually. When we look at our actual equity stake in the company, we can see that the value has barely changed over the same time period. The equity stake per share that investors own in the company is not increasing over time. To me, that is a problem and a huge red flag.

Before investors buy into the newest great earnings story, they need to dig down to the balance sheet and see if the actual value of the business is growing along with the reported earnings growth. There may be more to the story, but before you can buy the stock, you need to know why this is the case. Have there been write-downs? Is management diluting your equity stale with new issuance of stock?

Eventually, everything is reflected in the balance sheet, and it's a much better measure of corporate performance than reported earnings per share.

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