Sometimes a penny makes a difference

By DAVID MOON, Moon Capital Management, LLC
March 13, 2011

In the book “Scorecasting,” author Jon Wertheim reports on an academic study about reported corporate earnings versus expected earnings. Researchers from Washington University and Duke found that companies were almost five times more likely to exactly match expectations or exceed them by one penny rather than fall short of expectations by a penny.

Given that a penny is such a small unit and that earnings forecasting is such an inexact science, one would expect about an equal number of one-penny shortfalls, one-penny positive surprises and exactly accurate predictions.

The authors conclude that companies manipulate (a-hem, “manage”) their earnings to insure that they don’t fall short of investor expectations. They do this by making assumptions about non-cash items, such as the value of inventory or expected losses from bad debts. Within some parameters, companies might choose to capitalize a purchase rather than expense it, spreading out the recognition of the expense over several years, and thus increasing their current reported income.

In the 2010 Berkshire Hathaway annual report, Warren Buffett recognized the potentially misleading nature of this corporate flexibility. “I could – quite legally – cause net income in any given period to be almost any number we would like.”

Cash flow is a much more useful measure of the value and of the general attractiveness of any business. Because it is difficult to manipulate (short of committing fraud), cash flow is much more volatile than net income. The smooth nature of a company’s net income – even if the smoothness is the result of manipulation – makes net income a more widely used measure of business value, however.

If you peruse any general or industry-specific stock research site, you will invariably see significant space and resources dedicated to reporting earnings surprises. The Wall Street Journal, Thomson, Reuters and Bloomberg all do it. Yahoo Finance and Microsoft Money do it.

If you’re picking your own stocks but don’t do it for a living, you might find it a bit daunting to calculate free cash flow or make assumptions about the required maintenance capital expenditures for a company. (It’s actually not that difficult with a little instruction and some common sense, but that doesn’t encourage more people to try.)

If you’re not going to include a free cash flow calculation in your investment analysis process, you can still get some value knowing that net income is a highly misused and often misleading measure. Don’t give much credence to a penny or two of difference in a company’s earnings, especially if the earnings are a penny greater than expected.

A company that exceeds expectations by only a cent could have easily manipulated that desired outcome.

Since companies are often penalized severely (via a stock sell-off) for missing earnings by even a penny, many will do almost anything to avoid that mortal sin.

A company that misses earnings by a penny probably warrants more careful attention. Since there is an empirical bias toward companies outperforming expectations, an investor may conclude that company executives will do almost anything – within the law – to avoid reporting disappointing results. Missing expectations – even if by only a penny – might signal the beginning of a real problem.

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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