Yesterday’s Wall Street Journal headlined an article with “Investors Await Profit Reports with Wary Eye.” The thoughtful practitioner should wonder about coverage such as this: Why is it news?
News, according to the Merriam-Webster Online Dictionary is “(a) a report of recent events, (b) previously unknown information, and (c) something having a specified influence or effect.” The headline is certainly consistent with part (a) of the definition—any casual conversation with investors will inevitably turn to recent or expected earnings reports. But so what? It is old news, and therefore inconsistent with (b). In my three decades of reading this paper, I cannot remember a single counterfactual article, such as “Investors Yawn at Forthcoming Profit Reports.” Yesterday’s headline reminds me of that old chestnut often reported in the financial press, that “selling was particularly heavy today.” As James Grant, the perceptive observer of Wall Street has commented, buying has to have been equally heavy–down to the last share.
My chief issue with the headline has to do with part (c) of the definition: focusing on profit is inconsistent with neither what investors do or should do. Profit is a flawed measure of corporate value: it is backward-looking, is vulnerable to earnings management, and ignores a host of factors that matter to investors (such as flows of funds for investment or financing). Best practice investors, such as Warren Buffett, take a very different approach to the valuation of corporations: they look forward in time, estimate cash flows, and discount them to the present. In this context, quarterly profit reports only matter as a possible clue to shaping one’s expectations of future corporate cash flows.
The Journal’s editor would probably offer a defense based on “wary” in the headline. At this date, investors may be worried that the economic cycle is topping out, or worse still, declining. But rarely does it happen that investors aren’t wary: there is sufficient volatility in corporate performance over time that share prices are often out of synch with the realities in the stores, factories, and marketplaces in the world. The good investor is always wary.
I have written and lectured about the vagaries of investing on the basis of quarterly earnings per share (E.P.S.) (for instance, see chapter 16 of my book Deals from Hell) and have found no one to defend the conventional practice of riveting attention on quarterly E.P.S in terms any loftier than the claim that everybody seems to do it. Such is herd behavior of the worst sort. The tough-minded practitioner can, and will, see through this.
Financial journalists should too. An article on investors warily awaiting quarterly earnings reports is not new news–the Journal has consistently reported such stories over the years. Moreover, suggesting that profit is a good metric of corporate value is not consistent with best practice, and thus, not worthy of the column-one-above-the-fold prominence given the article. It must have been a slow news day.
Bob Bruner
Dean, Darden School of Business
Posted by Robert Bruner at 07/11/2006 03:32:18 PM