In my last post I talked about the role of financial theory in dictating that more forward-looking information be provided by investor relations.
In short, if financial theory holds that that the value of a firm is equal to the sum of its future cash flows, discounted back to a present value, then one of the jobs of investor relations is to provide enough forward-looking information to investors to allow them to make reasonable estimates of future performance.
Most investors, in making these estimates of future value, will construct financial models because you can’t just pick a number out of the thin air. Over the years I have seen a number of variations on how models get constructed, using earnings per share, EBIT, EBITDA, NOPAT and free cash flow to name a few. They are usually constructed using a five-year horizon but some optimistic modelers use a ten-year horizon. However, no matter how they are constructed, they operate in the same general manner, taking values in time, computing a final terminal value, and discounting the values and terminal value back to a present value, using a discount rate. As a result, some general observations can be made that can help investor relations practitioners keep the big picture in mind.
First, because most models rely upon year-over-year compounding, consistently improving earnings will be valued more highly than inconsistent earnings. Mathematically speaking, if a company’s earnings fall from 100 to 50 in a year, they have declined by 50%. However, in order for earnings to get back to 100 in the following year, they must go from 50 to 100, a 100% increase. When plugged into models that rely upon year-over-year compounding, erratic earnings in the form of years that show a decline in earnings result in much lower valuations than companies that consistently grow year-over-year. This is something that most investor relations officers understand intuitively, but it’s always nice to know there is an underpinning financial theory to it.
Secondly, also as a result of the way compounding and discounting work, investors will value consistent earnings more than the promise of big profits in the later years. This is the ‘Bird in hand’ theory. So-called ‘hockey stick’ projections, where earnings are flat for several years until the big payoff come in the later years, are less valued for two basic reasons:
- first, discounting – the farther out into the future you push future profits, the more they get discounted. Additionally, the farther out in the future they are projected to occur, the more uncertain they become and investors assign a higher discount rate to them. Higher discount rates result in lower present values
- second, compounding – the earlier one receives profits, the more compounding will occur, resulting in a higher present value.
The final effect of compounding and discounting to consider from the way financial models work is that a projected change in the earnings estimates has a greater effect in the earlier years than it does in the later years. Thus if an analyst trims estimated earnings for next year it has a greater effect on the estimated fair value of the stock than it does if the estimated earnings for year five are lowered.
Not all earnings projections are created equal and those closer to the present carry a greater weight.
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