Friday, August 8, 2014

Reacting to Earnings Reports: Let's get real!

In my last two posts, I considered how earnings reports can generate narrative shifts or changes, thus affecting value, and pricing effects, when companies trail or beat investors’ estimates on metrics (earnings per share, revenues, user numbers etc.). In this one, I intend to apply the lessons in those posts to three companies that I have been working with over the last couple of years: Apple, Facebook and Twitter. In particular, I would like to look at the most recent earnings report for each company, the news each report contained, the distractions in each one and the effect on stock prices. I would also like to look at the information in past earnings reports for each company, over the entire (limited) histories for Facebook and Twitter’s, and the last two years of reports for Apple, with the intent of incorporating what I have learned into updating my narrative for each company.

Apple Earnings Reports: The Meh Chronicles

I looked at Apple in detail a few months ago, chronicling my estimates of value for the company and stock price movements starting in 2011 and going through April 2014. The graph below reproduces my findings (with prices and values per share adjusted for the recent seven to one stock split), with an update through August 2014:
Apple: Price versus Value (My Estimates)
Note that while stock prices have ranged from $45 to close to $100 over this period, my value estimates have had a much tighter range, reflecting my largely unchanged story line for the company, over the period. Starting in 2011, my narrative for Apple has been that it is a mature company, with limited growth potential (revenue growth rates< 5%) and sustained profitability, albeit with downward pressure on margins, as its core businesses becomes more competitive. I allowed for only a small probability that the company would introduce another disruptive product to follow up its trifecta from the prior decade (the iPod, the iPhone and the iPad), partly because of its large market cap and partly because I thought it had used up its disruption karma over recent years. 

Looking at the earnings reports from the company over the last nine quarters, it is remarkable how little that narrative has changed. In the first two sets of columns, I report on Apple’s revenues and earnings per share and contrast the actual numbers with the consensus estimate for these numbers in each quarter. For much of the time period, Apple has matched or beaten revenue and earnings estimates, albeit by small amounts, but the market has been unimpressed, with stock prices down on six of the nine post-report days and seven of the nine post-report weeks. 
Apple: Earnings Reports from July 2012 to July 2014
Note that after controlling for the quarterly variations, revenues have been flat or have had only mild growth and operating margins have been on a mild downward trend.  With Apple, the other focus in the earnings reports has been on how iPhone and iPad sales are doing and the table below reports on the unit sales that Apple reported each quarter, with the growth rates over the same quarter’s sales in the prior year. In the last two columns, I report Apple’s global market share in the smartphone and tablet markets, by quarter. 

Apple: Unit Sales for iPhone & iPad, with global market share
While the market fixation with Apple’s iPhone and iPad sales may be disconcerting to some, it makes sense for two reasons. First, it reflects the fact that Apple derives most of its revenues from smartphones/tablets and that the growth in unit sales and change in market share therefore becomes a proxy for future revenue growth. Second, Apple’s earnings are being sustained by its impressive profit margins in the smartphone and table businesses and looking at how well it is doing in these markets becomes a stand-in for how sustainable the company’s margins (and earnings) will be in the future. Each quarter, there are rumors of another Apple disruption in the works, but each time the promises of an iWatch or an iTV don’t pan out, investor expectations that Apple will pull another rabbit out of its hat have eased. 

The most recent earnings report seems to reflect this period of stability, temporary though it may be, for Apple, where investor expectations have moderated and the company is being measured for what it really is: an extraordinarily profitable company, with the most valuable franchise in the world. It seems to have stabilized its position in the smart phone world, is seeing its tablet market shrink and its personal computer business is being treated as a rump business. In effect, analysts are treating it as a mature company that is being powered by the iPhone money machine, where margins are declining only gradually. Since that is the narrative that I have using all along in my valuations, I see little change in my assessment of intrinsic value for Apple. Allowing for the stock split, the value per share that I assess for the company, with the information in the new earnings report incorporated into my estimates, is $96.55, almost unchanged from my estimate of $96.43 in April 2014. With the new iPhone 6 launch just a few months away, I am sure that the distractions will start anew, and I think it is prudent for me as an investor to map out an exit plan, if the stock price rises to $100 or higher. If it does not, I will happily continue to hold Apple, collect my dividends, and hope for a disruption down the road.

Facebook: Bigger than Google?
I valued Facebook just before its IPO in this post, and argued that the stock was being over priced at $38 for the offering. The tepid response to the offering price made me look right, but for all the wrong reasons. The botched IPO was not because the stock was over priced or because the market attached a lower value to the stock but largely due to the hubris of Facebook’s investment bankers who seemed to not only think that the stock would sell itself but actively worked against setting a narrative for the company. My initial valuation, though it will look conservative in hindsight, was based upon the belief that Facebook would be as successful as Google in its growth in the online advertising business, while maintaining its sky-high profit margins. 

Looking at Facebook’s earnings reports since its IPO, there have been nine reports and the market reaction has shifted significantly over the period.
Facebook: Earnings Reports & Price Reaction
I think that the botched public offering colored the market response to the very first earnings report, with the stock down almost 25%. In fact, I revalued Facebook after this report, when the stock price plunged below $20, and wrote this post, arguing that there was nothing in the report that changed the narrative and that the company looked under valued to me. I was lucky enough to catch it at its low point, since the company turned the corner with the market by the next quarter and the stock price more than doubled over the following year. I revisited the valuation after the August 2013 earnings report, and chose not to change my narrative, leaving me with the conclusion that the stock was fully priced at $45 and that it was prudent to sell.  Looking at the earnings numbers over the nine quarters, it is clear that has Facebook has mastered the analyst expectations game, delivering better-than-expected numbers for both revenues and earnings per share for each of the last seven quarters. 

With Facebook, the market has also paid attention to the size and growth of its user base as well as the company’s success at growing its mobile revenues. In the table below, I list these numbers as well as Facebook’s invested capital each quarter (computed by adding the book values of debt and equity and netting out cash) and a measure of capital efficiency (sales as a proportion of invested capital):
Facebook: User Numbers, Revenue Breakdown & Invested Capital
This table captures the heart of the Facebook success story: a continued growth rate in a user base that is already immense, a dramatic surge in both online users and advertising and improving capital efficiency (note the increasing sales to capital ratio).  The most recent earnings report provided more of the same: continued user growth, increased revenues from mobile advertising and improved profitability, both relative to revenues and invested capital. Looking at the last report, I have to conclude that I was wrong about Facebook’s narrative remaining unchanged, for the following reasons: 
  1. While my initial reaction to Facebook’s success on the mobile front was that it was what it needed to do to sustain its narrative as a successful online advertising company, the rate at which it has grown in the mobile market has been staggering. In fact, I think that there is now a very real possibility that Facebook will supplant Google as the online advertising king and continue to maintain its profitability. That is a narrative shift, which will translate into a larger market share of the online advertising market, higher revenue growth and perhaps more sustainable operating margins (than I had forecast). 
  2. The inexorable growth in the user base, astonishing given how large the base already is, has also been surprising. That remains Facebook’s biggest asset and a platform that they can try to use to enter new markets and sell new products/services. Facebook has also shown a willingness to spend large amounts of money on acquiring the pieces that it needs to keep increasing its user base and build on it. The downside of this strategy is that growth has been costly (though the costs are hidden for the moment in the financials), but the upside is that is putting in place the pieces it needs to monetize its user base. While the revenue breakdown does not reflect this business expansion yet, I think that Facebook is better positioned for a narrative change now than it was a year or two ago. 
My updated valuation for Facebook reflects these adjustments. Incorporating a higher revenue target ($90 billion, rather than $60 billion) and more sustained margins (40% instead of 35%) , I estimate a value per share of $63 today. For those of you who have been taking me to task for selling at $45 in September 2013, I commend you for your foresight in holding on to the stock, but I am at peace with decision for two reasons. First, given what I knew in September 2013, I did what I had to do, given my investment philosophy, and second guessing it now is an exercise in futility. Second, if the biggest regret I have in my investing life is that I sold a stock to make a 150% return rather than holding on to it to make a 300% return, I would consider myself to be truly blessed. I may be compounding my mistake here, but at $72, I don't see it as a bargain, and I am in no hurry to buy the stock now. For those of you who are Facebook stockholders, though, this may be one of those companies where the value could chase the price for years, as the company finds way to turn the possible into the plausible and the plausible into the possible, and I wish you only positive returns.

Twitter:  The Early Returns
In the weeks leading up to the Twitter IPO, I wrestled with valuing the company. In the valuation that I did in the week before the IPO, the narrative I offered was of a company that would become a significant but not a dominant player in the online advertising business. I argued Twitter’s strength (the 140 character limit on messages) would also be its weakness, and that businesses would be loath to make Twitter their primary advertising platform. My targeted revenues in ten years were still substantial, and in conjunction with a healthy profit margin of 25%, yielded a value per share of $18, well below the offering price of $26 and even further below the opening day price of $46. 

In the months since, Twitter has had three earnings reports, and the accounting results are summarized below, with analyst expectations and the stock price reaction to each report. 
Twitter: Earnings Reports and Price Reactions
Twitter’s first two earnings reports were received badly by the market, though the company beat revenue forecasts on both, partly because the company continues to lose money. The most recent earnings report received a rapturous response immediately after it came out, though some of the rapture seems to have eased in the days after.  Even more so than Facebook, the market has focused on secondary numbers at Twitter, with particular attention being paid to the growth in the user base. In the table below, I list these other numbers: 
Twitter: The Other Numbers
The negative reaction to the second earnings report was partly due to the low growth (relative to expectations) that Twitter reported in the number of users and the positive reaction to the last report seems to be traceable to Twitter beating analyst expectations for user growth in the most recent quarter.  Looking at both the accounting and user numbers, what is striking about Twitter is how little the company has changed over the period that it has been in the market. The proportion of revenues it receives from advertising has remained around 90%, its revenues from international sales have increased only marginally and its mobile advertising has stayed at a high percentage of revenues (which is not surprising given that its compact format travels well to mobile devices). Its use of invested capital has not become more efficient and while you may argue that this is early in the game, contrast Twitter's evolution with Facebook's over the first few quarters.

There is nothing that I see (and I may be missing some key component) in these reports that would lead me to reassess my initial narrative, i.e., that Twitter will be a successful, but not dominant online advertising company, and the last earnings report only reinforced that view. There was some good news in the report, especially on the revenue front, but there was some game playing that was needless, in my view. First, as this article points out, the user numbers includes those who are not Twitter users in the conventional sense but are exposed to tweets in the context of news stories. Since these indirect users will not get to see (and therefor click on) the sponsored tweets that are the company’s advertising mainstay, I think that including them with total users is a little misleading, though the company may not have intended to be deceptive. Second, and this is not a problem specific to only Twitter, is the claim that the company actually made money, if you do not count stock-based compensation as an expense. As I argued in this post, this is nonsense, but I blame the analysts and investors who buy into this fiction just as much as I do the companies that feed them the fiction. In fact, as I listened in on the Twitter earnings call, I was left with the uneasy feeling that this was an earnings report produced for equity research analysts, by an equity research analyst, in terms of the numbers it emphasized. It may be pure coincidence that Twitter acquired a new CFO between its last report and this one, and that in addition to being a banker who led their public offering, he was an equity research analyst in a prior incarnation, but I don't think so. 

Incorporating everything that I have learned from these reports into my valuation, I see little movement in my intrinsic value. Even allowing for a much more efficient use of capital in the future, my estimate of value per share is $22.53. It is still early in Twitter’s corporate life and like Facebook, and I did see this news story about Twitter perhaps entering the online retailing world, and while it may be just as much a sign of desperation as hope, it is true that young company narratives can change quickly. There is a lot more about Twitter (and its business model) that I do not know than I do, and I would like to see Twitter come through on their promise of better metrics of user engagement with their business model. 
  • I am curious about how many users actually click on the sponsored tweets. I don't like to extrapolate from personal experience but I not only have never clicked on one (or even been tempted to do so) but I find myself irritated to see tweets in my timeline from businesses trying to sell me their products and services. For Twitter's sake, I hope that I am an outlier.  
  • I am also curious about how much it is costing Twitter to get new business (how much does it cost to add an advertiser) and what their pricing system for ads is. After all, surging revenues don't have much value, if your costs to deliver those revenues surge even more.
As someone who uses Twitter a lot more than Facebook, I would like to see the company succeed, but as an investor, I remain a skeptic.

The Bottom Line 
I could go on with other companies but I think I will outlive my welcome. With just these three companies, I hope that I have been able to bring home two salient points about earnings reports. The first is that while it is always the most recent earnings report that people tend to focus on, there is value in looking at a time series of reports, since there are patterns that may emerge from that series. The second is that the patterns you observe should feed back into your narrative and valuations, reinforcing your existing views in some cases, changing them in small ways in other cases and shifting them dramatically in still others. The earnings report trail is leading me to different destinations: with Apple, to an exit point, with Facebook, to a shifting of perception on what the company is worth (though not to the point of being a buyer at its current price) and with Twitter, to no real change in my perception that while the company has promise but is over priced.


Josh H said...

How do you control for bias in your inputs? Even though your price targets for AAPL have been less volatile than the chart, your valuation still changes dramatically (at least in my view).

I have held the belief that AAPL should trade around 12x ex-cash because growth cannot happen forever (in a few years, AAPL would have 100% market share of phones). I now feel the push in my own mind (even though I am cognizant of bias changes) to upgrade the PE in AAPL to 15x. PE growth for the rumored IPhone 6 (larger screen - the main reason why I don't have an IPhone), the rumored iWatch and all the potential benefits to health, and the new CFO that is more aggressive in buying back stock (increasing EPS growth).

UniverseofRisks said...

Why would you exit apple if the stock crosses $100? Wouldn't you sell apple only if the narrative for the company changes for the worse. Does it not seem like you are playing the pricing game?

PS: big fan.

Anonymous said...

You claim to be value investor, but what you do seems to be market timing to me: jumping in and out hoping that your valuation is correct.

How is your approach different from a market timer who jumps in when he thinks things are cheap and jumps out when he thinks things are expensive?

You don't want to have confused students, do you?

Aswath Damodaran said...

If your definition of a value investor is someone who buys something that is undervalued & holds forever, I am not one. If it is someone who buys something that is under valued, keeps revaluing at regular intervals & sells when it is overvalued, I may qualify. To be honest, I don't particularly care about whether the value investors' club lets me be a member. I find many of its current members to be rigid (I don't think that the world revolves around Ben Graham), ritualistic (I am perfectly okay never going to Omaha for the rest of my life) and righteous (I don't think traders are consigned to valuation hell).
In my world, intrinsic values changes all the time, though less than prices do, and my investment process is a continuous one that does not end when I find a stock to buy.

Anonymous said...

Thank you so much for clarifying your investment philosophy. However, the ultimate test of an investment approach is how it performs over time.
Have you ever disclosed the performance of your portfolio? How is it compared to the index funds or the rigid, ritualistic and righteous approach of the Ben Graham Club?
You are one of the finance people I respect the most. However, it would be hypocritical of you if your students and online followers don't know how you perform in real life, not just in terms of theory and logic. An example of hypocrisy is Jim Cramer. He goes on TV telling people to buy and sell specific stocks every day but his own personal portfolio consists mostly low-cost index funds because what he tells others just doesn't work.

Aswath Damodaran said...

First, it is hypoctrical only if I try to tell you to buy or sell stocks or get you to adopt my investment philosophy ( which Cramer does). I have used this blog to explain what I think about investing, not sell you on it. Second, you have much better data than a self-reported portfolio return which you cannot check. I have posted on almost every stock that I have bought or sold in real time when I did it for the last five years. So, you know that I sold FB too early, that my YHOO holding is still struggling, that my VALE & PBR investments had a flat first year. So, do with it what you want. As I have said repeatedly, every investor needs to develop his or her own investment philosophy & take responsibility for their investment choices.

Hector said...

Hi Aswath,

Just a concern regarding your blog. Even though I have subscribed to the email (from 2 different accounts), the mail is never delivered to my ID. I think your feedburner is not processing these things properly. Kindly look into it.

Anonymous said...

Prof. Damodaran,
I am done with playing devil's advocate and want to let you know that I follow your blog faithfully. Every time, I read what you write, I ask myself how can one be so smart and so productive and write so well too. Your students are very lucky to have you as teacher. Having said that, I have to say that Bill Gurley gave you a run for your money re the Uber valuation.

Unknown 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.

David said...

Hi Aswath,

I´m learning value investing and I would like to ask you if you have any writte up about the importance of return on capital employed, and how to calculate it?


Aswath Damodaran said...

You are persistent but I don't plan to return to Tesla until I have a clearer sense of the narrative for the company. At the moment, I don't know what the end game for the company is yet. I know that you have a narrative you feel strongly about & I wish you the very best with your investment but I am a slow learner.

Anonymous said...

Hi Prof -

Will you discuss your exit plan in general? Or, how would you do it for Apple as an example?

Unknown said...


I'm quite puzzled by your response.

It was not at my request that you twice in the past year wrote blogs on Tesla declaring it was highly overvalued based on a decade long forecast of its business you created.

These blogs that were picked up by various media outlets including the Wall Street Journal. At your discretion and obviously not my invitation, you took both your narrative of an overvalued stock, and the public's trust and respect for your position as a PHD in finance onto CNBC to lay out that narrative.

Now, if you tell me today, you are not confident that you have enough information to value the stock, I will not argue with that. However, how can you claim that this is due to your "being a slow learner", if you already twice quite publicly delivered valuations on the company saying it was overvalued.

If you've learned that those conclusions were made to hastily, and rather than a slow learner, you were premature in your conclusions, isn't it only fair to the public, Tesla's shareholders and would be shareholders to clarify this situation... to let it be known as publicly as those CNBC appearances that you in fact do not think Tesla is overvalued, as you now realize the reality of your perception of Tesla's future is not clear enough to make a valuation call, nor was it clear enough to call it overvalued when you twice did so this past year.

Not to be super heavy, but Professor, please, really think about what you think is fair and what kind of world you want to live in.

All the best,


Aswath Damodaran said...

Let's agree to disagree. When I say that the narrative is in flux, it is because I thought that Tesla was an electric car company at the start of the year. For much of the year, all the talk that I have heard from the company is about its electric batteries, but that story was undercut by Musk's offer to give away the battery technology. Perhaps, the company is reorienting itself and I will have to factor that into my next valuation.

For the moment, though, I would not buy Tesla at $230, $180 or even $150. You obviously believe otherwise. So, you should hold on to your stock and I won't try to talk you out of that decision. Please return the favor and leave me to my valuation.

Anonymous said...

I don't think Bill Gurley's post was better than Prof's post or the other way around.

It is just the perspective with the information and certain bias of course one had while doing valuation.

I am more prone to buy into Prof's views on Uber than Bill's because when you have a large stake you usually tend to defend yourself.

What would make out of Uber in the coming years is anybody's guess (including insider managers); it is a tough business and I don't think there is too much of barriers to entry. Therefore giving it a large market share, network effects, and so forth is probably a fantasy.

To be fair to Prof, let's just give him his space where he can lay down his thoughts. Many learn out of it.

Regarding value investor and all that stuff, it is all nonsense. There is either an investor or a trader speculator. Investor tries buy low and sell high based on fundamental analysis. Trader tries to do so based on market trend analysis. My personal opinion is trader is never going to make money consistently over time, while investor has a chance.


Ash said...

Thanks for sharing your valuable knowledge on this blog and your iTunes class for free. Its yet another example of "best things in life are free."

GoPro has been gaining a lot of marketing hype recently, would love to hear your thoughts on the stock.

Unknown said...

Aswath, I am confident that there is far more here for you than how I sense things seem to you based on your comments.

I can see you have the possibility of knowing who we are and I am confident that you can find encouragement. Our discussion of Tesla is a small matter compared to this.

I wish you well,


Anonymous said...

Professor, thank you for these posts, and sharing your thoughts. I enjoy reading every one of them. Would you please also share your take on LinkedIn? Best wishes to your health.

Anonymous said...

I really enjoy reading your blog and learned a lot.

Are you going to post something for Alibaba(BABA)?

Please say yesssssss!

Anonymous said...

Do you take requests? SPLK would be an interesting one to look at.

Unknown said...

How do you control for bias in your inputs? Even though your price targets for AAPL have been less volatile than the chart, your valuation still changes dramatically (at least in my view).
ngoc rong online

Anonymous said...

> "I think it is prudent for me as an investor to map out an exit plan, if the stock price rises to $100 or higher...."

Just curious: have you sold your AAPL (the $100+/share target has reached recently)?

I have not sold a share yet. As long as the iPhone growth continues (market share is not a good indicator because AAPL does not play to "junk" phone game).

My key observation is this: Android is a training device for people to buy iPhone later.

Howard said...

Hi Prof. Damodaran,
Would the announcement of Apple Watch and Apple Pay change your outlook on Apple? Or is that still too early to tell?

Anonymous said...

I hope you did not sell your AAPL shares near $100.

There are lots of factors in valuing a company that cannot be measured by looking at available data.

I am still amazed by people waiting for days outside Apple stores just to buy the latest iPhones. Also, look at the prices people are asking to sell their iPhone 6/6+.

mattlesnake said...

We miss your Apple valuations and it's been nearly a year since your last. If you have any thoughts I'm sure you'll have many interested readers :)