Stock Valuations on Earnings versus Cash Flow

(ProQuest: ... denotes formulae omitted.)I. INTRODUCTIONAt Berkshire Hathaway's 2002 annual shareholders meeting, Buffett said "We'll never buy a company when the managers talk about EBITDA. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Walmart, General Electric, and Microsoft. The fraudsters are trying to con you or they're trying to con themselves."The most celebrated investor's message couldn't be clearer. In terms of value, it is what you can take out of a business that really counts, not the earnings reported by the company. A major earnings-centric culprit is the equity analyst community, which has a clear bias toward earnings when formulating forecasts. An examination of the widely used IBES database indicates that only 15% of the equity analysts reporting provide estimates on future cash flow, yet all of them routinely make earnings forecasts. This evidence manifests the fact that for public firms there is a disproportional emphasis on earnings.One problem with earnings focus is that forecasts of future earnings have been known to be overly optimistic. On September 21, 2001, despite a negative cash event, Amazon.com was trading at an unreal price/earnings ratio (P/E) of 2000 at time when its stock was $192. The only way to justify such a lofty price level would be as if Amazon's earnings were to grow at an annual rate of 80% for the next 10 years. When its price peaked at $225, Amazon's market capitalization of $52 billion was larger than the GDPs of 125 countries. This exaggerated valuation has since been explained as an example of "stock market myopia" - investors' fixating on short-term earnings.Furthermore, since 2002 there has been a new movement led by the CEOs of top blue chip companies such as GE, Microsoft, and Intel to voluntarily stop providing earnings guidance, with the goal to relieve managers from being boxed into hitting short-term targets, and investors from being misguided. The critics claim, rather, that the firms are self-serving, especially since most of the firms that stopped issuing earnings guidance had already experienced poor earnings and stock performance. This is evident by a separation between public opinion and stock prices. When surveying online regarding whether the practice of earnings guidance should be stopped, the "blog" comments were overwhelmingly supportive. Yet, market prices reacted negatively after firms announced to stop earnings guidance.8For the question at hand, two well-cited surveys produce contrasting results. In Block's survey of AIMR members in 1999, earnings was ranked as the most important variable than cash flow, book value, and dividend in valuing a stock. However, according to the Merrill Lynch Institutional Factor Survey, institutional investors used an average of eight valuation factors in selecting stocks, and price to cash flow was more widely used in investment practice than other value measures during 1989-2001. On average, 46.1% of the respondents consistently used price to cash flow. The inconsistency between the above two surveys does not help resolve the question of what variable(s) investors actually use in their valuation process. It is still puzzling as to why the masses appear to know cash flow is the correct pricing methodology, yet they continue to focus on earnings. This, however, cannot be explained by irrationality given its ubiquity throughout the stock market history.Another duality is investors' drastically different approaches to valuing publically traded stocks versus private equities, though the lack of public information for private firms somewhat dictates the obvious difference in thinking. By law, private firms are not required to disclose information, except to the holders of debt instruments to whom the relevant information is the change in cash flow that reflects debt-servicing ability. It is not surprising that firms that turn private also switch their focus on financial reporting from earnings to cash flow. …