Dig Beneath the Earnings Hoopla

 | Jul 06, 2013 | 1:30 PM EDT
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As the holiday week drew to a close, I spent a little time thinking about Wall Street's general obsession with reported earnings. For the next few weeks, everyone on the Street will track, study and make guesses about the quarterly earnings reports that the majority of public companies will be issuing. Stocks will be bought and sold wildly based on what someone thinks the number is, what the number actually is and how badly all the analysts failed to guess the number. I cannot think of a bigger waste of time and money.

I read quarterly earnings reports for the companies I own and for those I am interested in owning. Unlike most people, however, I pay only cursory attention to the income statement at first. The answers I seek are found in the balance sheet.

I want to see if the balance sheet has improved or worsened. What's going on with cash levels, receivables and inventories? Did the company pay down debt or borrow more during the quarter? I can find out everything I need to know by comparing the balance sheet on a year-over-year and sequential basis. Over the long run, I am tracking the growth in tangible equity per share. That is the best indicator of a growing company and of management's successful allocation and investment of capital.

On the flip side, I have found that one of the best ways to locate a future busted growth stock is to find a company with dazzling earnings-per-share growth over time, but lagging growth in book value. These companies might be in a good place at present, but management may not be reinvesting the profits in a manner that earns high returns. Or they could be using a very high level of capital expenditures and costs to manufacture earnings growth. In these cases, it is likely that the current favorable conditions will not last, and that earnings growth will revert to match the growth of the value of the company.

Big Lots (BIG) is a great example of just such a stock. Wall Street is a fan of the company's 21% 10-year earnings growth and 27% five-year EPS growth. However, the money has not been reinvested in the business successfully; the company's book value has grown only by 4.5% over the past decade. The five-year rate of 7% is an improvement, but this is still well below the rate of growth in EPS. Management isn't sharing those earnings with shareholders, as the stock pays no dividend, and cash flow growth is lagging behind that of EPS. Management has been paying down long-term debt, but this is not spurring any surge in the total equity value of the firm. It appears that a lot of money is being spent here that's doing very little to increase the net worth of Big Lots.

Let's turn to another example of management failing to add value when reinvesting earnings -- one that comes from one of my favorite groups to hate. Strayer Education (STRA) was a very hot growth stock for much of the first decade of the new century, and management actually grew book value as much as it did earnings. But, in the past five years, things have imploded as the for-profit education industry has sagged under the weight of the economy and increased regulatory attention. The total value of Strayer's equity has been falling even as reported earnings growth has exceeded 20% for the past five years.

Things will not get better any time soon, it appears, as business conditions are horrible. Student enrollments are still declining, as are new student starts. The company has been adding debt, and cash balances are declining year over year. I see no reason to invest in a company that, at 10x the equity value of the stock, is destroying shareholder value.

Wall Street tends to get very excited about these quarterly reports and loves to see eye-popping figures that surpass its own predictions. Meanwhile, companies have become too intent on delivering numbers that please traders and give a short-term boost to their stock price. But if you look more deeply into the earnings report and favor the balance sheet over the income statement, you will often hear a different story from the one proclaimed by the top line. If you are buying growth, make sure that growth is increasing the value and strength of the whole company.

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