Wednesday, August 6, 2014

Reacting to Earnings Reports: Narrative Adjustments and Value Effects

Reality shows seem to have taken over much of television, but I am not a fan for two reasons. The first is that I don't enjoy watching people who are either so psychologically damaged that they like living their lives in a fishbowl or are so economically desperate that they do not have a choice. The second is that while I recognize the draw of these shows comes from their unscripted nature, I prefer getting my reality jolts from two other forums. The first is live sports, where the allure is that no matter how scripted a sport is, there are those moments of magic, where anything can happen. The second is financial markets, which delight in bringing investors and especially market experts to their knees by behaving in unpredictable ways. Just as ratings week is when television shows are made or ended, earnings season is when the markets deliver their biggest surprises. Building on a theme I introduced about narrative and numbers in an earlier post, I would argue that earnings reports are the vehicles that we should use to confirm, reject or modify narratives (and thus value).

Narrative Adjustments: The Real World Intrudes
In my post on narrative and numbers, I argued that valuation acts as a bridge between the story tellers and number-crunchers and that in a good valuation, every number should be part of a story and that the story has to be checked for viability against history, common sense and data. I also argued that big differences in value can be attributed to differences in narratives rather than differences in numerical assumptions.

So, let’s say that you have taken this message to heart, constructed a defensible narrative and converted that narrative into a valuation. That narrative, and the valuation that is built on it, cannot be etched in stone, since the real world will deliver surprises, positive as well as negative, that should lead you to revisit your narrative. While some of these narrative-changers can come from macro economic developments and occasional news stories about the company, earnings reports remain the primary mechanism for delivering news about companies. While much of the focus in these earnings reports remains on the bottom line, often defined as earnings per share, and investors react to whether that number comes in above or below expectations, it is also true that these reports can contain news that should lead you to revisit your narrative and change your valuation. I would broadly classify these narrative effects into three categories:
  1. Narrative breaks/ends: The most dire scenario is news that leads you to conclude that your existing narrative for the firm is no longer operative, rendering your original valuation moot. Narrative breaks are almost always bad news and can be caused by legal events (e.g., the Supreme Court decision that brought Aereo's disruptive efforts to a halt), economic events (e.g., the Argentine government default and its effect on the valuation of any Argentine company), government actions (the nationalization of a company or the removal of protection from competition) or credit events (a company's failure to make a debt payment, resulting in bankruptcy). 
  2. Narrative shifts: In most cases, earnings reports don’t deliver large surprises about a company’s business model or direction, and this is especially the case for mature companies. Instead, you get is information that lead you reassess your narrative and extend that reassessment into new estimates for the company’s future revenues, earnings and cash flows, shifting value. This is the exercise, for instance, that I chronicled in a post about Apple's earnings report on April 23, 2013, where I deconstructed the information in that report and looked at its impact on key inputs into Apple's valuation. Note that narrative shifts, especially if they are consistently positive or negative can lead to major changes in company value over time. This has been the case for a company like Google, which in spite of all its innovations and new services, derives almost all of its revenues still from online advertising but has done it so well that it has managed to expand both the size of the overall online advertising market and its share of it over the last decade.
  3. Narrative changes (expansion/contraction): In some cases, earnings reports deliver news that may be peripheral in terms of the impact it has on operating numbers (revenues, earnings) but are significant because they signal that the company’s business model is changing in ways that you had not anticipated in your original narrative. No company has epitomized this process better than Amazon, a company that I have valued multiple times since 1998. In my very first valuation of Amazon, I valued it as a book retailer, but in subsequent valuations, I have seen it evolve first into a specialty retailer, then become a general retailer, and in recent years, make forays into the media, entertainment and cloud storage businesses. I am sure that there are people more prescient than me who saw all of this coming in 2000, but I sure did not, though notwithstanding that vision failure, I still found Amazon to be cheap (and a good investment) at least four times in the last decade.
Narrative Shifts versus Narrative Changes: Shades of Gray
This distinction between narrative breaks, shifts and changes is a good one to think about when you look at earnings reports, but it is not alway easy to make. In fact, it is entirely possible that you and I could look at the same earnings report and come to very different conclusions about its impact on narrative for three reasons:
  1. Your classification (break, shift or change) will depend upon your initial narrative: The more expansive your initial narrative, the more likely it is that you will see narrative shifts, rather than radical changes. Let me take Uber as an example, and use the contrast of my narrative with Bill Gurley's  to illustrate this point. Uber is still private but any information that I receive about Uber’s success in suburban markets will be a narrative change for me, since my base valuation is built on the presumption that Uber will be successsful as a urban car service company. For Bill Gurley, whose base narrative already incorporates expectations of sucess in suburban markets, this news will be more of a narrative shift than a change.
  2. The lines between the categories can become fuzzy: Even for a given narrative, information in an earnings report or news story can fall in gray areas and be tough to categorize. For instance, Facebook’s better than expected performance in the mobile advertising market in its last few quarters may be viewed by some as just a narrative shift (giving them a larger market share of the online advertising business) and by others as a narrative change (with the mobile users giving them a platform that they can use to enter other online businesses), with very different implications for Facebook's value.
  3. Narrative adjustments can vary across time, for the same company: As a company reports earnings over many periods, you can see narrative shifts in some periods and narrative changes in others, good news in some and bad news in others. Staying with Amazon, a company that I used as my example of a successful narrative changer, the market reaction to the last two earnings reports has been brutal, as markets seem less  focused on revenue growth (which continues to be extraordinary) and more on profit margins (which have been abysmal). A narrative shift may be occurring, where investors are reassessing Amazon’s potential profitability in steady state and concluding that it will make less money than they thought it would.
Narrative Adjustments: Reactive and Proactive Valuation Responses
How do we deal with these narrative adjustments in conventional valuation? Very badly, I am afraid. If your valuation is a rigid discounted cash flow valuation, your response to narratives breaking, shifting or changing is denial. In that static world, the narrative remains constant, your valuation inputs stay the same, intrinsic value never changes and it is the market that is viewed as being at fault for its volatility. Even those who claim to use more dynamic processes for valuation often stay within the traditional framework, trying to increase discount rates to reflect potential narrative breaks and growth rates to capture narrative changes.  Finally, even the best among us tend to be more reactive than proactive, adjusting value for narrative adjustments that have already occurred, but not making any attempt for the potential for adjustments in the future.

By definition, since you cannot anticipate the unexpected, you have to draw on the full arsenal of valuation tools to both react to narrative adjustments as they happen and to proactively incorporate the possibility of future adjustments into value.  While the reactive effects of narrative adjustments on value are straight forward, incorporating expectations of future narrative adjustments into current value is much more difficult to do and the table below lists some of the tools that we have available:
  1. When valuing companies where the possibility of a narrative break is high, either because they are young, start-ups or debt-ridden, distressed companies, you have to bring in the likelihood of the narrative ending, explicitly as a probability. (See my papers on valuing young companies and declining, distressed companies for estimation tools that you can use to make this judgment)
  2. For narrative shifts, where the effects play out as better-than or worse-than expected revenue growth and profit margin numbers, the tool that works best is a simulation, where you use probability distributions for the inputs into your valuation rather than just your base case numbers and estimate a distribution of values. (See my paper on probabilistic approaches in valuation)
  3. For narrative changes, which, by definition, are unanticipated and unexpected, you have to treat them as real options and value them as such. (See my paper on the promise and peril of real options)
In the table below, I summarize this discussion of narrative adjustments, how they affect value when they do occur and how you can proactively bring them into your valuations:

The Bottom Line
Earnings reports remain a company's key delivery mechanism for news about both its operations and plans of the future, but they are filled with distractions. Paraphrasing Nate Silver, it is important that we separate the signal from the noise and use these reports to revisit our narratives and valuations. If you are an avid market watcher, you may feel that I am over analyzing the earnings process and that the market reaction to an earnings report has little to do with narrative shifts or long term value, and more to do with meeting investor expectations on key numbers (earnings per share, revenues, number of users etc.). I don't disagree with you and in my companion post, I will focus on the metrics that investors use to judge earnings reports, why these metrics might vary across companies and over time and the potential danger of letting these metrics determine investment decisions. 


Anonymous said...

Dr. Damodaran-

One correction to this article. MLPs are not require to payout 90% of their income like REITs. The only requirement for MLPs is for 90% of their income to be from qualifying sources (i.e. energy). The partnership agreement stipulates that MLPs must distribute all "available cash"; however, the definition of "available" is left to the discretion of the general partner.

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