Tuesday, October 18, 2011

Current Earnings vs Pre-Crisis Peak Earnings: Coca-Cola, Pepsi, Google, Wal-Mart, and Microsoft

With all the market noise and a focus on near term results it's worth taking a step back. Here's a look at each company's peak earnings pre-crisis (before 2008) compared to earnings this year*.

Coca-Cola (KO)
Expected current year earnings/share: $ 3.84/share
Pre-crisis peak earnings/share: $ 2.57/share

Pepsi (PEP)
Expected current earnings/share: $ 4.41/share
Pre-crisis peak earnings/share: $ 3.41/share

Google (GOOG)**
Expected current earnings/share: $ 32+/share
Pre-crisis peak earnings/share: $ 13.29/share

Wal-Mart (WMT)
Expected current earnings/share: $ 4.49/share
Pre-crisis peak earnings/share: $ 3.13/share

Microsoft (MSFT)
Expected current earnings/share: $ 2.85/share
Pre-crisis peak earnings/share: $ 1.87/share

The focus on short-term movements in the stock price seems to sometimes mask this progress.  Each of the above has materially improved a main driver of their intrinsic value....the capacity to earn. It's not as if we're in an economic boom. They're all making a nice living despite plenty of headwinds.

The increased earnings power is certainly not driven by cyclical factors.

Changes in stock price in the short to even intermediate run reflects market sentiment, macro issues, and various other perceptions (true or not) of a business. Stock prices can change fast but the intrinsic value of most businesses rarely do.

Sometimes a stock price is substantially higher than intrinsic value entering a particular period of time. Google's as good an example as any. The hype around Google's stock had it selling at over $ 700/share the year it earned its pre-crisis peak earnings of $ 13.29/share. More than 50x earnings.

Similarly, the stock of Microsoft and Wal-Mart have have gone nowhere this past decade precisely for this reason. They entered the decade with a stock price well in excess of even an optimistic view of intrinsic value.

So earnings had to "catch up". The returns may still turn out okay in the long run if the business continues to create value. Yet, paying a price above intrinsic value creates increased risk of permanent capital loss or below par returns relative to risk if the business stumbles.

What business doesn't stumble from time to time?

In contrast, let's say an undervalued stock continues to get cheaper while the business does fine (or, at least, long run prospects remain sound despite headwinds).

In this case, the long-term owner shouldn't mind. In fact, long-term owners should hope that it gets even cheaper in the near term.

The lower price just provides more opportunities for both the shareowner to buy more shares below intrinsic value and management, via buybacks, to do the same. As long as something is selling below intrinsic value and especially if, like the businesses above, intrinsic value continues to grow.
(None of this refers to any trading scenarios, of course...an entirely different game.)

A rising or falling stock price often creates its own dynamic that spills over into the perception of business performance. What psychologists have called the "halo effect" and first documented in the U.S. Army decades ago. From this Wall Street Journal article:

In this quirk of the human mind, one powerful impression spills over onto our other judgments of a situation.

Wall Street Journal: The Halo Effect

The result: Investors think...they are evaluating the stock and the managers independently, but one opinion inevitably colors the other, often leading investors to be too bullish on the upside and too bearish on the downside. The managers haven't changed; our perceptions of them have.

It's easy to allow a positive or negative "halo" distort the perception of business value. Use of more objective factors is the best way to prevent misjudgments.

The discrepancy between price and value works itself out, eventually, but wide disconnects when in comes to price versus value can go on for a very long time (easily long enough for an investor to lose patience).

The above businesses appear to have made substantial progress on the value creation front in the past several years. Is that capacity to earn persistent? Will capital be put to good use that creates high return incremental growth? That will be the real determinant of long run value.

Some of these stocks have seemed to go nowhere in recent years (though opportunities have been there to buy them at a nice discount to value). Microsoft and Wal-Mart receive their fair share of coverage in this regard.

Dead money, right?

Yes, but it had little to do with what the businesses accomplished.

The above businesses have been creating value. The problem was the cheap became cheaper or the shares were overvalued in the first place and earnings had to catch up.

Adam

* Coca-Cola, Pepsi and Google end the fiscal year in December of 2011. The Wal-Mart fiscal year ends in January 2012 while the Microsoft fiscal year ends in June 2012. 
** I'm using Google's more conservative GAAP earnings. Many analysts use the non-GAAP number. Either way Google's capacity to earn has been improved substantially.

Established long positions in KO, PEP, and GOOG when selling at much lower price levels. Also long WMT and MSFT slighly below recent prices.
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