Don’t fail to consider that the current financial markets are ever more becoming driven on a day/day pricing basis by algorithmic and non-algorithmic short-term traders – as contrasted as being driven by long-term holders.

Earnings Don’t Always Reflect Expectations

If you participate in the financial markets, either directly or indirectly, it is important that you understand the role earnings plays in acquisition analysis as contrasted with stock market analysis.

An April 20 article by a Senior Editor at Lombardi Financial is titled Earnings Reflect Expectations – the Stock Market Is Fairly Valued.  The article goes on to suggest that based on quarterly earnings currently being reported and are expected to be reported for Q1 2012 that has just ended:

• those earnings “are a mixed bag”;
 
• “the stock market is holding up very well, because the earnings results aren’t really that stellar”;
 
• “the trend in corporate reporting so far this earnings season will continue”;
 
• “earnings are good, but not spectacular”;
 
• “the stock market reflects the current outlook from companies.  It is tepid”; and,
 
• “the stock market is appropriately valued … and a lot more upside from current levels is unlikely”.

Earnings are a public equities markets driver for a large number of analysts and financial market participants.  In the end the financial markets are ‘the financial markets’ and how those markets price stocks and hence, for financial market purposes, imply point in time values for companies – being the company’s market capitalization – can’t be disregarded.  However, latest reported earnings are rife with conceptual issues from a number of perspectives, including:

• reported earnings are ‘accounting constructs’, and have built into them many subjective underlying accounting theories, reporting decisions, and quantifications that can skew earnings results for any given company from quarter to quarter, and from company to company within the same industry sector in the same financial reporting period;
 
• reported earnings are nothing more or less than ‘recent historical snapshots of operating and non-operating results’ that may prove to be not representative of future performance; and,
 
• value of a company’s shares at any given point in time is a measurement of the present value of the future expectations of all discretionary after-tax cash flow, not earnings, that company is expected to generated.  Discretionary after-tax cash flow is the amount a company is left with after expending maintenance capital to invest in growth or provide a dividend (or other payout return) to its shareholders.  Broadly, the referenced present value calculation typically is based on an assumption that the company will generate positive discretionary cash flows to infinity (or at least as long as its operations are expected to continue – e.g. in part ‘mine life’ for a mining company).

This leaves ‘reported earnings’ as little but a simplistic and unreliable ‘value driver’ in the ‘real world’ of corporate merger and acquisition transactions.  The one caveat to this is that public company acquirers in their acquisition analysis do (or should) calculate the likely affect an acquisition will have on the acquirer’s post-acquisition reported earnings to ensure – to the extent possible – that the acquisition is ‘accretive’ to its then consolidated earnings.  Stated differently, the acquirer works to satisfy itself that it will achieve post-acquisition synergies that will result in the financial markets pricing the acquirer’s shares based on earnings analysis at an implied amount greater than the price the acquirer pays for the acquisition target.

While because as an investor you can’t disregard earnings reports because the market doesn’t, earnings reports are more relevant to short-term investments and trades, and less relevant to long-term investment strategies.

Don’t fail to consider that the current financial markets are ever more becoming, or so it seems, driven on a day/day pricing basis by algorithmic and non-algorithmic short-term traders – as contrasted as being driven by long-term holders.

Ian R. Campbell, FCA, FCBV, is a recognized Canadian business valuation authority who shares his perspective about the economy, mining and the oil & gas industry on each trading day. Ian is also the founder of Stock Research Portal, which provides stock market data, analysis and research on over 1,600 Mining, Oil and Gas Companies listed on the Toronto and Venture Exchanges. Ian can be contacted at .(JavaScript must be enabled to view this email address)

Note: The Commentary and information above is provided ‘AS IS’ and solely for informational purposes, not for trading purposes or advice.