Everything You've Been Taught About How to Value a Stock Might Be Wrong

statements that big companies are publishing. Right. Yeah, it comes four times a year, and it's one of the you know, one of the most exciting times of the year, especially if you're a stock investor, because it's when you know, the companies reveal all of the stuff that they did in the last quarter, the revenue, how much they made, how much their balance sheet, highlights of the quarter, and it's when you really have a chance to dig in because you have a fresh snapshot of the state of

the company. Right. But there's a lot of work that goes into estimating earnings results even before they come out, right, Like, analysts will be tweaking their models ahead of results season, and then they'll be tweaking them after. Everyone is sort of digging into the numbers to try to determine how well or how badly a company is doing. Absolutely, and one of the things that I think a lot of people don't get if they're not really active in markets.

Is that there's no such thing is objectively good or bad earnings, because in markets everything is about relative to expectations. So you can have a company that doubled their earnings and made a billion dollars this year versus a billion more than last year, but if the market was expecting them to make one point two billion dollars more than

the stock might tumble. Conversely, you can have companies that lose a ton of money, but if people were impressed by some you know, their revenue growth, or people were impressed that they were expected to lose more, uh, they the stock might surge. And as such, it's the sort of like the classic kynesie and beauty contest. You don't just try to figure out the company is gonna earn, but we also try to figure out what the crowd thinks the company is going to earn and how the

actual results match up to expectations. Right, And some people say that things have gotten even more complicated in recent years because you have companies that sort of try to talk down expectations before their results and so inevitably they end up beating already low forecasts. So there's lots of moving parts to this isn't there. But Joe, what if I told you that digging into earnings is a useless exercise.

If you told me that it was a useless exercise to dig in like this, I would be completely crushed because a part of my job is to talk about this and be One of my first jobs was doing equity research for a small portfolio management company, and that's what I spent hours and hours going through every one of these lines. So please don't tell me now. I'm sorry to get scared. Why are you? Why are you hinting that maybe it's all the waste of time? Don't

be scared, Joe. What I mean is it might be useless to dig into those earning statements in a sort of traditional sense. Basically, there are some people out there who think that the way we use current accounting rules are the way that accounting rules have been implemented, doesn't really match the realities of our modern economy or our modern business environment. Okay, so let's get your I'm still a sort of waiting for the build up here. You'll be fine, You'll be fine. Okay, We're going to talk

to Baruke Love. He's professor of Accounting and Finance at Stern School of Business and Fenggu Associate Professor of Accounting at Sunni Buffalo. They put out a paper which was fantastic on this exact subject, basically arguing that our accounting standards haven't really kept up with big, big changes that have overtaken the economy in recent years. So let's get over to them. Buruke and Fang, welcome to the show. Thank you, thank you, Thank you for having us. So

was that intro accurate? Is the some of your work essentially that accounting methodology hasn't really adjusted to modern realities. I would say the intro is very accurate. It's not just that we claimed that earnings don't matter. We actually prove it. Uh. In a recent article we published, we show for all companies that even if you had the dream forecasting machine, meaning that you could focus, you could identify all the companies that we meet or beat consensus

analysts focused next quarter. You're not longer to make anybody. You're not going to make any money from this. You used to in the past, big money, but no longer. And most people are not aware of the demise of earnings as an indicate of company performance. Evaluated of manager's capabilities. So we actually prove it both in a recent book that we wrote and in in the article. And this is this is really I would say earth shattering, but it's effect. This is indeed earth shattering. I mean, this

is in fury. This blows up the premise of so many of our conversations, which as we say, okay, Facebook earnings are coming out, or GM earnings are coming out, and they're expected to earn a dollar and a penny per share, and they earn only nineties seven cents. And as you say, we try so hard to get this right. Let's say, maybe let's start from thinking, so, where did the if it's not right, where did it come from? Where did we get this idea of how we traditionally

talk about earnings. The centrality of earnings comes from the work of Graham many years ago. He was the celebrated teacher of warm Buffett, and since then earnings are the center of all the models that analysts are using. Everything is aimed at predicting forthcoming earnings. Managers are pestor to

provide some guidance for forecasting earnings. Everything revolves around earnings, and the reason, of course, a reason why so many so much money goes to index fund and to automated investment managed funds are not doing well, and we claim that the main reason why they're not doing well is

because their focus on earnings is completely misplaced. Right, And you have, like you said earlier, if if someone built the perfect earnings prediction machine, there was a time when you could have made big money from that, and now it doesn't seem to be the case. So what exactly has happened there? What happened is that it used to be that earnings really indicated performance of companies. Thirty forty

years ago, earnings basically indicated revenues minus real costs. Since then, there was a revolution in the business models of companies from tangible to intangible assets. You don't make money anymore from machines and equipment and building. You make money from patents and brands and information technologies and human resources. Everyone knows it, everyone uses it, except for accountants that were

really asleep at the wheel and still are. And all those huge expenses of companies in intangibles are expensed in the income statement, meaning they are charged against earnings. So the earnings that you get today are completely misstated. For some companies, they are overstated. For other companies they are understated. Just think about the Amazon in the last four or five years, they missed half their consensus earnings. Nothing happened to them. That's of course a marvelous companies with a

huge market value. Think about Tesla, incredible brand, with accumulated losses of one and a half billion dollars because they are forced to expense all their investments. A much smaller, less known company like Kite Farmer, which works on very advanced cancer research. You look at the financial reports accumulated losses of six hundred million dollars. They were just a week ago bought by gilly Out Sciences for twelve billion dollars.

I mean, the financial reports completely mistaked the picture of the company, the performance of the company, the future prospects of the company. And that's where we are now. And that's why, that's the reasons of the failure of the traditional analges of companies focusing on earnings. Again, these are not just claims that we make article. We demonstrate that the lass of earnings relevance over time is really driven by companies that invest a lot of money intangible assets.

So Over time, investors eventually realize that the earnings information, the profit laws, and the balance and information investors look at is no longer relevant for evaluating the performance and the value of these companies. So to be clear, just to clarify that a little further, there was a point in which that magic earnings oracle would have made you a lot of money had you had it. And you demonstrate in your paper that the value of that information

in advance has declined. Can you talk us through a little bit that's sort of the quantitative evidence you show that that isn't useful information anymore. Sure, Going back to the late eighties and early nineties, um, the gains from this dream machine of perfectly predicting future earnings would allow you to earn access profit in the magnitude of twenty five percent each year. This is in access of market and risk adjusted returns. So those were the good days

of playing this earnings prediction game. Now, moving to the current time, as off the end of two thousand fifteen, the same process would earn you no more than two percent of access return. And there are of course a lot of treating strategies that can earn you even better access returns at much lower cost. Before we get into you know, I will obviously I want to talk about what we should be looking at instead of the traditional earnings.

But before we get into that, it's still you know, it makes me uncomfortable because even with all of the changes in business models an intangible assets, it still seems like an intuitive basis that the measure of a company is like, okay, but did you make money or not in this quarter? And how much money do you have today? And how much money do you have three months from now, and that ultimately, for as weird and as different as business models get, profit is still the point of business.

It sits in a little bit uneasy with me that ultimately it still wouldn't come back to just how much money they made. You're right about the importance of how much money you're you're making now and of course even more important, how much money you'll make in the future. What we claim is that earnings measured according to the

accounting rules today don't even reflect this. That's why, for example, in our in our recent book The End of Accounting, we show that if you base your analysis on cash flows, you will be better off then if you'll do it

on earnings. So you're perfectly right. It's of course of great importance how much money you make, but reported earnings don't measure how much money you make by the way managers know it, and that's the major reason why they release all those non gap earnings which are so derided by our people. Some of them are, of course a little massage manipulated, but by and large this is a manager will response to the inability of currently measured earnings

to reflect what actually happens in corporations. Right, So it feels like every earning season we get a news article about how reported gap figures are veering away from adjusted earnings, and lots of people have problems with adjusted earnings because they think they're they're vulnerable to manipulation either by managers

or analysts might read too much into them. But you're arguing that there are more accurate representation than traditional gap accounting, or that they feel a sort of gap left by gap. I guess again, it's not. It's not just my argument. It's the result of lots of research projects that are confirmed that investors react more strongly, most forcefully to non gap earnings than gap earnings. So investors find by enlarge, non gap earnings is much more informative than gap earnings.

That's again effect. These are things that are very easy to research, and these are the findings. Thing I think you mentioned Amazon, or maybe we're talking about Amazon and Tesla, and of course Amazon is sort of famous for people discarding their earnings or even their non gap earnings that you can have these quarters will they'll lose money and the stock shoots up, or they'll give a guidance range that's so wide is to be laughable, but it doesn't

really matter to people, and people keep buying. The story that pundits like to tell about Amazon is that Jeff Bezos has done such a good job training Wall Street to not care about quarter to quarter profits that they can get away with huge investments and huge losses from

time to time. But it sounds like what you guys are saying is that the way we characterize Amazon is a little too pat and that actually Wall Streets response is not about some training or anything like that, but essentially about investors just sort of understanding, like in any company, the numbers that really matter, and that earnings aren't really it. That's that's absolutely true. So what we have advocated in a book as well as the article, is this notion

of strategic assets. What really matters to accompany success and the competitive at UH is not just current quarters earnings of profit. It's UH their strategic asset that give them long term value in market competition. So for a company like Amazon, what investment has delivered to them is the growth of their strategic asset. If you think about their market share, their expansion into more and more market territories, that's the proof that they're growing their strategic assets very strongly.

And the investors certainly understand this. At the end of the day, they're not just going to look at the quotally profit or loss or Instead, they're going to pay a lot of attention to amazon strategic assets. All the assets have been investment, invested, deployed, and what kind of

value has been created by these assets. To interject the cautionary note here, we are speaking about Amazon and Tesla, and investors definitely understand these companies because they are led by extremely articulate and charismatic leaders and the men search is clear. But there are thousands of companies out there without Jeff Bezos and other charismatic leaders that their message is not well understood and investors don't see the truth. They are still relying on the reported numbers, which are

misleading them. So that's why I think our message is so relevant today. If investors knew everything, we would even write this article now, but they are not. It's only for a few companies with those very effective CEOs or CFOs that can spread this message. The other thing I'm wondering is your findings. You know about this perfect earnings estimator and the fact that it wouldn't be much of

an edge in the market nowadays. Does that say more about how the market is functioning than the deficiencies of the accounting rules themselves, because one of the criticisms of the current market is that valuations no longer matter. You know, people aren't really investing on fundamental terms. They're just sort of following the money and it's all momentum based. So you're right, there a lot investing on the fundamentals or less than a fewer and fewer people are investing on

fundamentals because it faces them. I mean, they see the results quarter of their quotas and it's it's really not working. What we are saying is, don't abandoned fundamental analysis. You still have very good information out there. You're focusing on the wrong information, but you can shift and focus on the right information and you will be much better off. Okay, well, you know, before we wrap up, we have to talk

about what these things are. So okay, you mentioned that, for example, it makes sense to not he too closely to traditional gap earnings. You also talked about the importance of having strategic assets. But for many companies that sounds like it would be something that you know, it's unquantitative or something fuel based. Let's talk what are the things in an earnings report, in anything else that we should really be focusing on instead to start building a mental

model of what a company is worth. So I'll give you a couple of examples. If you're talking about pharmaceutical and biotech companies and you have a huge number of these companies, what they earned last quarter or last year, it's completely irrelevant to the future. What is relevant is what's called the product pipeline, the drugs, the instruments that they are developing. And all companies are providing very detailed

information page of the page of the page. It's not required by accounting rules, but they are doing it on the product pipeline. So if the company has products in advanced stage of development, is two clinical tests, face three clinical tests, they are close to the market, high likelihood that new products will come out of them. This company is at a very good stage. I would invest in such a company. I don't care about the earnings of

such a company. Talk about my second example, Internet companies, even insurance companies, media and entertainment. There's main strategic assets are customers. Look at the main data. Look at how many customers are being added every quarter. Look at the churn rate, which most people are not aware of. Churn rate meaning the center of customers they lose every quarter. That's what indicates the future, not the current earnings last earnings that they report. Basically, for every industry you have

those fundamental strategic asset that create the you. For most companies, this information is given and the focus should be on the performance of these assets, the potential of these assets.

Just just to play Devil's advocate, though, you talk about companies with drugs and stage two trials, But even then, to value that drug, don't you still have to come up with some model of how big the addressable market could be how much profit that drug is going to I mean, doesn't it still just come back to that being a tool to come up with some estimate of

future earnings. Yes, you can do it and actually think and I developed such a model because they are they are quite reliable data on the likelihood of drugs in phase to get into the market, and then you have the market size for the drug. So ultimately you can come up with prediction of revenues from the drug. But the focus of analysis is not trying to predict just the revenues, but looking at the fundamentals what creates the

value in all tasks. With this new mesthology, we actually have seen evidence showing that this different way of evaluating from suitable companies fundamental actually produces information signals that lead changing their market value. In other words, um, we can actually see the change in the value of their product pipeline before investors actually realize scenes are becoming different. Well, I'm sure we could talk about accounting all day, but

we have to leave it there. That was baruque love and thank Goog, Thank you so much for joining us. Thank you, thank you so Joe, does that make you feel better or worse? About your previous career as a financial analyst. Well, you know, I'm no longer a finance chill analyst, So I guess it makes me feel good that I left that, you know, had I had. I just stuck to trying to estimate EPs and all that stuff. But uh no, in all seriousness, it is really interesting.

I mean, one of the things I wonder is, like, to what extent do investors, you know, already sort of let these other factors determined I mean, the value of companies. It's not like all companies have the same PE ratio,

the same port forward pe ratio. To some extent, it's pretty clear that things like network effects or an internal company culture that allows it to produce great drugs you would imagine, is already being reflected in a lot of people thinking about these companies, right, And you do have some pretty big companies out there that are highly valued

that haven't necessarily had that successful um earnings quarters. I guess I think I think what it comes down to for me, I think our guests they've identified a problem which definitely exists. I think you can say the accounting rules, for sure, are not well equipped to deal with the realities of an economy that's increasingly about research and development and you know, brand value and information technology as opposed

to um, you know, machinery and manufacturing. I'm not sure about the solution, because again, it's one thing to say, oh, investors should consider these strategic assets of a company, but at some point you do want to see those strategic assets converted into some sort of revenue, right, And that's sort of like, you know, it seems like a theory you should be able to square the circle and say, Okay, it's great to have these strategic assets, but you know,

a strategic asset is only so good unless it produces revenue and income. But what I think is valuable here to me is like maybe we there's still it's like we have so many tuitive understanding that for all companies, whether it's an Amazon on one end, or whether it's a more standard industrial like a Honeywell or a g E on another end, that there's this whole spectrum of business models, and we sort of have this intuitive understanding that the sort of network effects or the customers are

the attention of some companies matters a lot more for others. But maybe we still overrate the importance of a traditional earnings company for for traditional stock, even when it's not particularly appropriate, and that we have to sort of adjust our dial to recognize that it's not the same thing, looking at a sort of P n L statement for a traditional industrial versus a P and L statement for an Amazon or a Facebook. Yeah, I think that's right

in any case. It's clearly a complicated topic, but something we can all keep in mind as earning season rolls on. And I'm very excited to read their book. I have it in front of me, The End of Account and the Path Forward for Investors and Managers by Baruke Lev and Fengu So thanks to them for joining us, and maybe we'll I'll read this and I'll get some more insight. All right, This has been another edition of the All Thoughts Podcast. I'm Tracy Alloway. You can follow me on

Twitter at Tracy Alloway. And I'm Joe Wisenthal and you can follow me on Twitter at The Stalwart. And I want to thank our producer Sarah Patterson, who's on Twitter at Sarah patt With two Teas. Thanks for listening.