Earnings not only measure of worth

By DAVID MOON, Moon Capital Management
August 31, 2003

Too many investors ignore the earnings of a company when evaluating an investment. They get excited or depressed by a report on CNBC or something they heard on the golf course. Ignoring earnings is a critical investment mistake. But blindly placing faith in earnings can be just as big of a mistake.

In June, DaimlerChrysler reported earnings that exceeded the expectations of most analysts. Profit margins were up; investors were excited. This was especially noteworthy, since the rest of the automobile industry suffered from a viscous price war in June. DaimlerChrysler, however, accumulated more than $800 million in additional cash during the quarter.

How did one automobile company manage to avoid the pitfalls experienced by its competitors? You didn't see substantially more new Voyager minivans driving around last month. If DaimlerChrysler didn't sell a bunch more new cars, what did they do?

They were foreign exchange traders.

Over half of their operating profits came from foreign exchange transactions - betting that the Euro would strengthen against other world currencies. If you focused solely on the earnings, you never would know that the operating results at DaimlerChrysler suffered like everyone else.

There is nothing inherently wrong with DaimlerChrysler engaging in foreign exchange transactions, particularly if intended as a hedge against the currency risk in its core business. But investors need to realize that every dollar of earnings is not equal. Some dollars are more important than others.

If Microsoft earnings increase because more people are buying Windows, that's one thing. But if Microsoft meets analysts earnings expectations by selling shares of publicly traded stocks it owns, those earnings increases have nothing to do with the operations of the company. They aren't nearly as significant as core operating earnings ' even if Microsoft categorizes the stock sales as operations.

For years, Coca-Cola would massage its earnings within a period by buying or selling bottling subsidiaries. It had nothing to do with how many Cokes people drank, but the results of the realized transactions would be reported as earnings.

Apparently, a dollar's worth of earnings at a Krispy Kreme shop is worth more if the company owns the restaurant rather than a franchisee. When Krispy Kreme buys a franchisee, they typically pay 7 or 8 times operating earnings. But investors currently value Krispy Kreme shares at 25 times operating earnings. If your favorite doughnut shop generates $300,000 a year in earnings, why are those earnings worth three times more if a public company owns the businesses rather than a local operator? They aren't.

Albert Einstein once said that everything should be made as simple as possible, but not more so. When you focus exclusively on a single number ' such as reported earnings ' you are trying to make something simpler than it is. Pay attention to earnings, but not blindly.

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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