After decade of great earnings growth, balloon is finally deflating

By DAVID MOON, Moon Capital Management
April 22, 2001

Two years ago, long-time value manager, Rick Ruane said, "what will separate the men from the boys is how we do when the music stops." About the same time, I asked a group of senior and graduate school finance students to project the earnings growth rates of a group of companies. Some of the companies were large, S&P 100 companies; some were small, obscure businesses. The common element in each projection however, was the students' uniform optimism. The lowest single year projected growth rate was ten percent. The worst year that any of the students thought any of these companies would experience was a one year earnings increase of ten percent. Average yearly earnings growth rates were all projected above 20 percent. Who could blame the students? That was all they had seen in their short adult lives. In Rick Ruane's words, the music was still playing.

I wonder if this fall's new crop of budding young analysts will have a different perspective?

Analysts estimate the S&P 500 companies experienced a nine percent decline in operating profits in the first quarter of this year, the largest one quarter decline since the 1990-91 recession. Second quarter earnings are expected to decline another seven percent. Every day for the last few weeks, it seems companies are announcing earnings shortfalls and larger-than-expected layoffs. Are we in a recession? Not technically, but the signs point in that direction. But there is no question that the heady earnings gains of the early 1990s are over, at least for now. What does this mean for stock prices?

The value of any company is simply the present value of the expected cash that business will generate for its shareholders/owners. If the growth rate of those expected future cash flows changes, so does the underlying value of the stock. Small changes in earnings projections can be significant.

Assume a company currently earns $1 per share. You expect those earnings to grow eight percent a year forever. (Ignore for a moment that no business could grow 8 percent a year forever without eventually becoming larger than the entire economy. Growth rates eventually slow, but I will keep the math simple. The effect is the same.) If you discount those earnings at 15 percent, the value of the stock that generates these earnings is $15.43 per share.

Now assume you slightly change your earnings projections for this company. Instead of assuming an eight percent perpetual earnings growth rate, what happens if you assume a five percent growth rate? The value of the stock drops from $15.43 to $10.50, an almost 32 percent decrease. A decline of only one percentage point in the expected earnings growth rate cuts the value of the company by more than 13 percent.

For years, many stock analysts projected earnings growth rates and stock prices like my students; they assumed the recent past would continue forever. Stocks at 35 times earnings were touted by analysts because the recent earnings growth rate was 30 percent or better. Never mind that a single year of negative earnings would make it that much more difficult to maintain that average in the long term.

In the 1961-62 NBA season, Wilt Chamberlain averaged scoring 50.2 points per game. Consider this: if Wilt scored only 30 points one night -- still a huge accomplishment by anyone's standards -- he had to score 70 points the next night just to maintain his average. A business is no different. A company with recent earnings growth of 30 percent that experiences a single year decline in earnings (or a loss) has a much higher, if not impossible, bar to clear to maintain those high expectations.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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