Both investors and traders have a tendency to assess a company’s performance by referring to just a couple of metrics in the earnings report, but this rough-and-ready approach is full of pitfalls says Aswath Damodaran, Prof of Finance, Stern School of Business NYU, in his blog post yesterday.
At the outset, Damodaran makes a distinction between an investor and a trader, pointing out that he has always associated the former with value and the other with price in their approach to the markets. For a trader, it is in fact desirable that she identifies and trades the very metric that other traders follow for their market decisions. Implicitly, since their outlook is short-term, these market participants are really not concerned with the larger picture, or the longer term associated with the value approach.
Blackberry Ltd – Earnings report: The dangers of an overly simplistic approach
For an investor seeking value, however, sticking to a simplistic approach by evaluating an earnings report on the basis of a couple of metrics such as earnings per share or the size of the company’s subscriber base, can lead to erroneous investing decisions.
Damodaran makes the point that investors look at certain metrics in isolation of the company’s status in its life-cycle. “These metrics can change as a function of where a company is in its life-cycle and (thereby expose the investor to) the dangers of focusing on metrics rather than value,” he says.
Earnings report: Company life cycles
Damodaran points out that a company would normally pass through the phases of
- identifying a market offering opportunity
- developing a product or service for that market
- create and implement a business model to offer that product or service for profit
- enjoy the fruits from an on-going and stable business venture
- manage the inevitable business decline due to competition or obsolescence
“The pricing metrics (and multiples) that investors focus on will vary across the life-cycle of a company,” says Damodaran.
Moreover, the value of a business is determined by many factors intertwined together he explains. “No single metric will ever capture all of these factors, and in using any metric “number of users, revenues, earnings), you are in effect assuming that everything else that drives value remains unchanged.”
Different metrics that apply during the various phases of a company’s life-cycle are presented in the table below.
The risks of narrowly focusing on a particular statistic include a blinkered vision and manipulation of data by companies to show a better performance on that metric (“game-playing” according to Damodaran).
But perhaps the most serious risk is ignoring that a company may have moved over to a new phase in its life-cycle, but continuing to apply an out-dated metric in the evaluation of its performance. This mistake could be committed by both investors and experienced analysts.
These transitions are unpredictable, says Damodaran, and may shock both companies and investors.
BlackBerry Ltd (BBRY)’s earnings report
We looked at a time line of BlackBerry Ltd (NASDAQ:BBRY) (TSE:BB) and juxtaposed it below Damodaran’s table of phases.
(It’s interesting that the stock price of the once hallowed smartphone maker follows a curve that is very similar to Damodaran’s graph of earnings/time)
But more important, what did the analysts and media say during these phases? As the company made the transition from boom times to decline, did their perceptions and ratings follow suit?
June 19, 2008
BlackBerry Ltd (NASDAQ:BBRY) (TSE:BB) stock touches a life high of $ 149.90 and then lapses into a decline from which it never recovered.
On the other hand, a couple of analysts remained obsessed with one metric – that of new product launches by a phone maker that was already behind the technological curve. See the comments below.
Blackberry Ltd June 26, 2008
RBC Capital quoted by a blogger on Seeking Alpha as follows:
“With the Smartphone market at inflection point and the company the best positioned it has ever been, RIM (at the cost of interim margins) is materially increasing investment (S&M, R&D) to achieve dominant global handset status. RIM expects its ‘strongest back half in history’, affirming RBC’s expectations for a broad consumer assault in 2H08, including new handsets (Touchscreen, Flip, Slider, 3G Pearl, others). The Firm notes historically (e.g. 2005, 2007) RIM made similar investments to address larger opportunities, which subsequently paid off handsomely for investors.
If management executes its strategy successfully and expands its addressable market, RBC expects rising investor sentiment as investors look past interim margin pressure and recalibrate around RIM’s full market opportunity. Maintains Outperform and $165 target.”
Blackberry Ltd July 9, 2008
Back up the trucks ahead of RIM’s (RIMM) new product launches, Canaccord Adams says. “This is the most compelling buying opportunity in the stock for the last 12 months.”
In fact the company was already in transition from a phase of ‘Harvesting’ to ‘Manage Decline,’ and this was the reality:
August 14, 2008
“Apple Inc (NASDAQ:AAPL)’s iPhone has shaken the cellphone industry, partly because of its design, but mostly because AT&T Inc. (NYSE:T) and Apple have allowed owners to download any number of applications to their phones. That freedom to individualize a phone’s functions has helped increase the popularity of the iPhone.
Phones using Google (NASDAQ:GOOG) (NASDAQ:GOOGL)’s software will do the same thing. Google is making the Android operating system software available free to an alliance of companies, including cellphone carriers and manufacturers who have agreed to provide devices which, like personal computers, allow users to decide which applications run on them.” (Brendan Gleeson)
Blackberry Ltd October 18, 2010
Steve Jobs makes a rare appearance on Apple’s earnings call – and opens fire on RIMM (“We’ve now passed RIM, and I don’t see them catching up to us in the foreseeable future”) and Android: Google’s “open” argument is a “smokescreen,” and he characterizes the battle as “fragmented vs. integrated.” (AAPL news).