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Great Expectations

November 5, 2013

At the end of the day, common stocks — the same stocks that comprise large portions of 401(k) and pension plans in addition to investors’ portfolios — are the discounted value of future cash flows. This is why, sometimes, the stock market, and especially particularly stocks, can move in ways that appear to be erratic or inconsistent with the news headlines. If a firm increases earnings 15% that would appear to be excellent news for management and stockholders, but what if estimates had the firm increasing earnings by 20%? The result would be disappointment and a decrease in the stock price, all other things being equal.

Like many other things in life, managing expectations is key.

Firms sometimes perform initiatives to help them meet earning expectations, and stock buybacks are an excellent example. According to an article I cited in a previous blog post, there have been $3.5 trillion in buybacks since 2008, and this has arguably led to earnings beats and increases in the stock prices of the firms that have performed these activities.

But is buying back stock that could artificially inflate earnings the best use of stockholder money, i.e., is it the best use of the funds that the corporation has?

Another aspect of managing expectations is how to manage the expectations of analysts when the firm is growing at an accelerated rate. Two excellent examples of trying to manage expectations are two of the best-known firms making market headlines at this time — Twitter and Tesla. Tesla has delivered surprisingly robust earnings during the last two quarters and jumped to a surprise profit last quarter that shocked the market. The subsequent run-up in the stock price has led many to speculate, including the CEO of the firm, that the stock price of the firm might be over-valued. As it turns out even the second quarterly profit in a row was not enough to satisfy investors, as Tesla was trading down approximately 10% in after-market action.

Twitter is due to go public this week, and as the firm continues to increase the IPO price and possibly the number of shares that is being offered, there are already doubts about the sustainability of the entity. The firm has yet to be profitable, but the possibility remains that the firm could be valued at $20 billion after the IPO this week — how is it possible to manage expectations of a $20 billion entity if the firm does not earn any money?

Food for thought.

Happy Reading


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