Wall Street glorifies companies that beat quarterly earnings estimates by arguing that the long term comprises a lot of short terms.
But beating earnings estimates for a few consecutive quarters doesn’t necessarily lead to long-term greatness. It assumes that significant changes to the business are visible in the reported numbers.
That’s likely what General Electric executives rationalized as they destroyed the company’s protective shareholder moat, its respected corporate culture, and its balance sheet.
Their short-term thinking focused on “beating earnings” on a quarterly basis, thereby insuring seemingly endless analyst upgrades. Unfortunately, GE’s short-term success that was seen by the market came at the expense of unforeseen damage.
Conversely, consider Apple reporting what analysts considered “disappointing” numbers for eight sequential quarters (three lifetimes on Wall Street) leading up to 2007.
During that time, Apple was pouring every ounce of its resources into R&D and coming up with the iPhone. It could not hire the right engineers fast enough, so it had to pull in engineers who had been working on the Macintosh (then Apple’s bread and butter). That resulted in delaying the introduction of new computers by a few quarters.
Did those negative short-term results subtract from the value of the company, or were they instrumental in adding trillions of dollars of revenue to Apple?
Quarterly misses and beats reflect only what can seen. But true investors are able to see the unseen.
With the luxury of hindsight, I picked two examples, GE and Apple, that could be taken to prove that earnings misses are great and beats are bad — but neither is true. “Beats” and “misses” are part of the vocabulary of the semi-staged reality game show that’s reflected on business TV.
Facebook for example, was recently accused of using casino gaming psychology to get users to keep coming back to see if their posts or family pictures were “liked.” Quarterly beats and misses are not much different: they add casino excitement to investing and turn unsuspecting investors into gamblers.
That doesn’t mean that an investor should completely ignore what happens in the short run. But quarterly earnings should be always looked at in the right context — the context of the long run.
Long-term thinking should be deeply embedded in stock analysis. A discounted cash flow (DCF) analysis model forces investors to value a company the way they would value a private business, bringing cash flows that lie decades in the future into the present.
But DCF analysis, though grounding, is a crude model that is most useful at the extremes of a company’s valuation, when a company is wildly overvalued or undervalued. This is why it makes sense to estimate a company’s value based on earnings multiples.
In my process, I look at a company’s expected earnings three to five years out and then discount it back (i.e., convert it to today’s dollars). That’s the key: Looking at a company’s earnings that far out muffles the noise of quarterly earnings — the “what have you done for me lately?” hysteria — and correctly puts the focus on the future.
Vitaliy Katsenelson is the CEO at Investment Management Associates, which is anything but your average investment firm. (Seriously, take a look). Sign up here to get his latest articles in your inbox.