A Critical Examination Of Earnings

A recent article made us think about the importance of definitions. The article states: "After all, in the long-run stocks are fundamentally driven by earnings and expectations for earnings growth." While we agree in part with this statement, we bet most people reading the article automatically think of earnings as net income and EPS. In reality, "earnings" is often used loosely to relate more to cash flow, which is a more important driver of stock price than accounting earnings. Remember, accounting numbers can be distorted much more easily than cash flow. There is another factor that is equally, if not more important, that is the required return. In increase in the required return on the market or a stock can often have a large impact on stock prices.

You Can't Keep A Good Twinkie Down

In 2013, facing imminent bankruptcy, Hostess, the maker of the iconic Twinkie, was sold for $410 million. Since then, the company has been turned around and a deal was recently announced that values the company at about $2.3 billion. Private equity group Gores Group bought Hostess and will take the company public. So, while you have been able to eat Twinkies, you will soon be able to invest in them again.

SunEdison Bankruptcy

In April 2016, solar energy company SunEdison filed for Chapter 11 bankruptcy.  Yesterday, the company won court approval for a $1.3 billion operating loan, but in an indication of the contentious nature of the bankruptcy, part of the loan is designated to fund a creditor probe into the company's activities, particularly in November. During that time, the company reconstituted the boards of two yieldcos, fired the conflicts committees of those yieldcos, and named Sun Edison's own CFO as the CEO of both yieldcos. A shareholder lawsuit in the bankruptcy argues, in part, that the corporate governance was insufficient as conflicts committees were reformed when the yieldcos would not prepay for solar projects that were being developed in India.

PE Ratio Math

As we mentioned in the textbook, when you are examining ratios, it is important to not only learn if a ratio has changed, but why it has changed. A recent article about the PE ratio highlights our discussion. Most people believe that an increasing PE is due to an increasing stock price, but as with any fraction, a change can also occur due to a change in the denominator. Currently, the PE ratio of the S&P 500 is about 19, above the 5-year and 10-year averages of about 16. As a result, many market analysts are predicting a declining stock market. However, even with a falling PE ratio, stock prices can still increase as long as earnings per share increase at a faster rate than stock prices. While we are not predicting the stock market, the article does note there are many periods in stock market history that earnings growth exceeded stock price growth, PE multiples declined, yet the bull market continued.

T-Mobile's Stock Giveaway

T-Mobile recently announced that it would reward customer referrals with a share of the company's stock. When a customer refers a friend who joins the company's network, T-Mobile will credit the customer's account in the amount of the stock price at the time, and for subsequent referrals, it will give the customer a share of the company's stock. T-Mobile will not issue new shares for the stock awards, but will purchase its shares on the open market. Of course, Uncle Sam will benefit as well. While the billing credit is not taxable, the shares of stock awarded will have to be listed as taxable income by the recipients. And when the stock is later sold, taxes will have to be paid on any capital gains above the original price.

Regulation A+ Funding

The IPO market has slowed down in recent years. From 1980-1989 and 1990-1998, an average of 204 and 401 companies went public each year, respectively. Compare that to the 2001-2015 period, when an average of 119 companies went public each year. Although there are various reasons as to why the IPO market has slowed so dramatically, the end result is that raising capital has become more difficult for small companies. Regulation A+, part of the JOBS Act, allows companies to raise up to $50 million in a 12-month period under certain conditions. Importantly, Regulation A+ allows companies to raise funds from non-accredited investors. While there are several possible qualifications to be an accredited investor, such as an income of over $200,000 per year, the number of accredited investors is limited. Removing the accredited investor restriction opens funding to a much larger number of potential investors. As this article discusses, with a tight IPO market, we may soon see a surge in Regulation A funding.

Share Repurchases And Value Creation

A recent article on the McKinsey & Company website discusses the effect of dividends versus stock repurchases. We are happy to report that the article comes to the same conclusion as the textbook: Repurchases do not necessarily create value and are equivalent to paying a dividend of the same amount. However, the article does bring out a couple of interesting points. First, while repurchasing debt (re-leveraging the company) results in a higher EPS, this is offset from the lower company risk due to less debt. The value of the company is unchanged (M&M), and the PE ratio should fall. Second, a more important point is that the company should undertake profitable, positive NPV projects, if available, rather than repurchase stock. In other words, a stock repurchase is essentially a capital budgeting project. A company should only repurchase its stock if the NPV from the repurchase is greater than other capital budgeting projects. Of course, if the market is efficient, the NPV from a stock repurchase is zero.