Wednesday, August 6, 2014

Reacting to Earnings Reports: Pricing Metrics and Market Reactions

In my last post, I looked at how earnings reports and other news stories about a company contain information that can lead you to reassess your narrative and consequently the value that you attach to that company. If you are an investor or analyst who is familiar with how markets react to earnings reports, you can legitimately argue that I am making this process more complicated than it has to be and that what you see at the time of the earnings report is a market reaction to how well or badly companies deliver on a specific pricing metric, relative to expectations. You are right and in this post, I will look at why investors often focus on these simple (and sometimes simplistic) metrics, how these metrics can change as a function of where a company is in its life cycle and  the dangers of focusing on metrics rather than value.

The Allure of Price Metrics
As you watch investors react, sometime violently, to a company reporting earnings per share that are a few cents below or above expectations, you may wonder why so much attention is being paid to a single metric and so little to the rest of the news in the earnings report. While I think the practice is dangerous, it can be explained with the following:
  1. It is easier to focus on a single number or metric than it is to develop a narrative and a valuation for a company. Consequently, investors and many analysts prefer to spend almost all of their time in coming up with estimates for that number, on the assumption that if they are right about those estimates, neither narratives nor valuations matter.
  2. In several earlier posts, including these on Apple and Twitter, I have drawn a distinction between value and price and argued that while investors care about the former, traders are much interested in the latter. If you are a trader, it makes complete sense to not only find the metric that other traders are using to judge companies (even if that metric is a weak measure of value and subject to manipulation) but to make estimating that metric the center of your investment strategy.
It is for this reason that I call this the "earnings game", where analysts and investors form expectations about a metric (earnings per share, revenues, number of users/subscribers), companies try to deliver actual numbers that beat these expectations and markets then react to the reports. I describe the process in detail in this post, with the aggregate evidence on both the market reaction to earnings reports as well as the post-report price adjustment process.

Pricing Metrics and the Corporate Life Cycle
While it is true that the predominant metric used to judge a company is earnings per share, investors sometimes use other metrics, rewarding Twitter for increasing its user base more than expected, pushing up Facebook's stock price for its success in mobile advertising and leaving Apple's stock price unchanged on the news that it sold more iPhones than expected, but fewer iPads. Given that investors choose one or two metrics on which they judge company performance, how do they decide which metric to use for a company? Using the narrative adjustment categorization that I introduced in my last post can provide some perspective:
  • For firms where the prime concern that investors have is about narrative breaks, the pricing metric reflects that concern. Thus, with young start-ups, investors may focus on cash in hand or access to capital, as proxies for survival risk. For distressed companies, the pricing metric may be linked to the company's capacity to service debt, interest coverage ratios or debt payments coming due.
  • For firms that have well established narratives, i.e., firms that have established business models in clearly defined markets, the focus will be on narrative shifts, and small ones at that. Given that the market size is stable and market shares are sticky, you can see why investors pay attention to earnings per share and react to surprises on that score. 
  • For firms where the narrative is still taking form, investor will shift away from earnings not only to top-line numbers (like revenues) but to other measures that are related to narrative change. With social media companies, for instance, that explains why investors pay attention to the number of users or measures of user intensity, on the assumption that companies can exploit larger values for either to enter new markets. 
Thus, the pricing metrics (and multiples) that investors focus on will vary across the life cycle of a company and this is the point that I hope to bring through in the picture below:
Life Cycle, Pricing Metrics & Multiples
Thus, early in the process, it is not irrational to focus on market potential or users, but as a company matures, the attention will inevitably turn to profitability and cash flows. Using real-world examples to illustrate this shift, a company like Yo, priced recently at $10 million by investors, even though it really has no product or service to speak of at the moment, is being priced entirely on market potential (all those people with smart phones whose notification center is accessible to apps like Yo). Moving further up the life cycle, consider Snapchat, a company that has a product with tens of millions of users but has not figured out a way to monetize them, it is the number of users and the frequency of their use that drives its pricing (with Alibaba willing to pay $10 billion for them). With Twitter, Linkedin and Yelp, investors seem to be making a transition, where revenues are clearly part of the equation, even though the number of users is still a key number. With Google and Apple, companies with established business models, revenue growth is a consideration but earnings clearly dominate.   

The Dangers of Pricing Metrics
While it is easy to see why investors focus on one or two metrics, when measuring company performance, the dangers of using these short cuts are manifold:
  1. Missing the rest of the story: The value of a business is driven by many determinants, including its capacity to generate profits (and cash flows) from existing assets, the expected growth rate in these earnings & the efficiency with which this growth is delivered and the risk in future cash flows. No single metric will ever capture all of these factors, and in using any metric (number of users, revenues, earnings), you are in effect assuming that everything else that drives value remains unchanged. To illustrate, a company that reports higher earnings per share but does so because it has entered riskier businesses, may see its stock price jump on the earnings report, even though its value has dropped.
  2. Tunnel vision: It is natural to develop tunnel vision, when your focus narrows. Investors and analysts who spend all of their time and resources refining their estimates of one or two metrics, whether they be revenues or number of users, will soon care just about those numbers and ignore the rest of the data (and story). 
  3. Game Playing: Once companies recognize that investors are focused on one or two metrics, it is natural for them to play the game as well. Thus, if analysts are unduly focused on earnings per share, companies will play accounting games to make their earnings per share look better than they should. I argued that the market's focus on the number of users at social media companies best explained why Facebook would pay $19 billion for Whatsapp
  4. Transition Phases: As the life cycle picture illustrated, investor focus does change as a company moves through the life cycle. It is therefore a given that at some point in time, as social media companies evolve and grow, investors will stop looking at the user base and focus first on user engagement with business models (revenues) and then on the profitability of these models (earnings). However, these transitions are unpredictable, and when they do occur, companies that think that they are playing by market rules (delivering more users than markets expected) may be shocked to discover that the rules have changed (and that they are being punished for losing money). 
The Bottom Line
To play the earnings report game, if you are a trader, you have to be able to both pinpoint the metric that markets will react to (which may not always be the metric that analysts following the company are focusing on) and be better at estimating how the company will do on that metric than other investors. If you can play that game well, it is a lucrative one but it is also risky, since seismic shifts can occur from quarter to quarter. That is why it may behoove traders to understand the narrative/value process described in my last post, even if they choose not to invest based upon that process.

Links
  1. Earnings Surprises, Price Reaction and Value
  2. Winning (losing) by losing (winning): The Power of Expectations
  3. Reacting to Earnings Reports: Narrative Adjustments to Value
  4. Reacting to Earnings Reports: Pricing Metrics and Market Reaction
  5. Reacting to Earnings Reports: Let's get real!

4 comments:

Anonymous said...

Dear Prof -

Take it from this former sell side analyst and an old student of your's... if investors had any idea of how analysts form their so-called estimates, they wouldn't pay much attention to them, if at all. But without estimates, all the fun of investing in stocks would dissipate and so would trading commissions and fees for brokerages, what's left of them. And what would cnbc etc have to jabber about all day long?

Steven H said...

Hi Aswath,

Wondering if you had a chance to do your own research on the points I discussed with you about Tesla in response to your 3/25 blog attempting to value the company (as you'll remember, I offered you some specific information about Tesla to help you see that you were dramatically overestimating both the amount of capital they would need to raise in the next decade, and future stock dilution to do so, and thus, drastically understating future earnings, and current valuation based on those earnings).

So, have you had a look at this? Did you end up buying shares? Did you wait and get an entry point in the range I suggested ($170-210)?

Will you be writing another piece on Tesla with a fresh look at the far more modest capex spending they will need to get to 1 to 1.5 vehicles sold per year?

Curious what you are thinking.

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