Stock Income Statement
Earnings refer to accounting earnings as reported on the "bottom line" of an stock income statement. These figures are separated into basic earnings per share and diluted earnings per share. Basic earnings per share are the total earnings divided by the average number of common shares outstanding during the period.
Diluted earnings take account of the possibility that some convertible securities and stock options could increase the number of common shares outstanding. This reduces the earnings per share by taking into account the conversion or exercise of those instruments. Focus on the diluted earnings per share (and bear in mind that even that figure does not always reflect full dilution or cost of stock options issued to managers, as we will see later).
In assessing what the enterprise can do for you in the future, you only have present and past earnings available. How can present and past earnings guide an assessment of future earnings? Or which of various prior year earnings or which combination is the "right" level of stock trading earnings?
In GE's case, four recent annual diluted earnings per share were $2.16, $2.46, $2.80, and $3.22; in Amazon.com's, negative $.06, .$24, $.84, and $2.18 per share.
Perhaps you should use only the most recent period. But what if, as with GE and Amazon.com, there is significant change in that year compared to the prior years? One issue is, of course, why that change occurred. Was it due to extraordinary factors that are unlikely to recur?
If that is the case, using the prior periods might seem appropriate, though a more precise gauge for companies that periodically experience such extraordinary occurrences is to lengthen the period to seven to ten years to iron out those bumps. Alternatively, perhaps the business is experiencing a steady positive or negative trend in its earnings. In these cases, averaging the earnings over the last four years makes sense. In GE's case, that is about $2.66 (in Amazon.com's, negative $.83).
All these issues obviously entail judgment, and on top of that you must recognize that the estimate is about future earnings. Taking the average earnings over the past four years and projecting them forward to the next four years requires a further forecast of the online stock trading earnings growth in the future period. Despite steadily rising losses, Amazon.com's management expects profits within a few years (as apparently do thousands of its stockholders, who at one point in the early 2000s drove its market capitalization to over ten times the combined totals of its profit-making archrivals Borders and Barnes & Noble!).
GE's earnings growth rate was about 12 to 15% in the late 1990s. You might cautiously expect similar or slightly slower growth in the early 2000s. Taking a conservative view of the future could justify a 10% growth rate—roughly $3.50, $3.90, $4.30, and $4.75, or an average of about $4.10.
In estimating earnings, note again the limits of accounting records. Accounting earnings result from subtracting cash expenses plus noncash expenses such as depreciation and bad debt reserves from gross revenue. This sounds simple, but the exercise entails making a number of decisions about how various events are accounted for. Accounting earnings are affected by a host of accounting conventions, including, for example, the method of computing the cost of goods sold, the method of depreciating fixed assets, and policies concerning allowance for bad debts.
But imperfect accounting rules are still effective. With respect to stock market earnings (as distinguished from, say, book value), accounting rules work when properly and consistently applied. Even if depreciation expense for fixed assets such as computers is not a perfect gauge of the future costs of replacing them when they wear out, for example, it does capture a minimum reasonable amount that must be reinvested in the business to maintain its sales level and competitive position in the future.
Once a representative earnings figure is selected, the earnings must be discounted. Doing this requires a suitable discount rate (conventionally called the capitalization rate or cap rate). It is the rate of return required to compensate for the risk of making the investment, and so it is equal to the risk-free rate (that available on U.S. Treasury obligations) plus an additional amount to reflect the particular risk of the business.
Assume you determine that GE's expected earnings over the next four will be about $4.10 per share. The price you are willing to pay for the right to that $4.10 per share in the future is a function of the rate of return necessary to compensate for the risk that the $4.10 per year will not materialize. It will equal the risk-free rate—say, 3%—plus a premium to induce you to take the risk of owning GE stock.
A robust debate centers on what the right cap rates are for different businesses and types of investments. In general, the lower the risks involved in a particular type of business, the lower the cap rate. For example, if there is a high degree of certainty that a business will continue to perform as it has in the past, a cap rate in the range of around 10% is appropriate. For businesses that present moderate degrees of risk, a cap rate in the range of 15 to 25% is better. For particularly risky businesses, those where uncertainty about future success is great, an appropriate cap rate could range from 30 to 40% up to 100%.
Businesses whose earnings fluctuate widely in the ordinary course may be seen as subject to a greater risk that estimated earnings will vary. For example, banks and insurance companies whose assets consist largely of cash or investments are more exposed to cycles of economic change and may warrant a discount rate in the range of 8 to 12%. Consumer products businesses—those selling foods and detergents, for example—tend to remain more stable during periods of both boom and bust and thus generally warrant a lower-risk cap rate in the range of, say, 6 to 8%.
In addition to depending on the risk-free rate of interest, an appropriate cap rate takes into account the rate of economic growth in the overall economy. During periods of steady economic growth and industry expansion, risks are relatively lower. During economic downturns, growth is less likely, even steady earnings are less likely, and there is a greater likelihood of overall earnings contractions. In such an environment, risk rises, and you should choose higher cap rates.
Therefore, the rules of thumb for cap rates have to be set according to the risk-free rate, the risks of a particular business, and those of industry in general. Equally important, we must adjust the cap rate to allow for future variations. If interest rates rise or the economy slows, for example, the cap rate will have to be increased, and vice versa.
The difficulties in estimating earnings and selecting a cap rate relate back to your circle of competence. Just as an appreciation of economic history is essential, knowledge of the operating context is indispensable for the forecasting exercise. GE, Microsoft, and Amazon.com all look exceptionally well managed, with Amazon.com even scoring some knockout points in the key ratios, though GE and Microsoft also make money from good management.
GE is a money machine, particularly in its capital financing division. It delivered steady earnings increases throughout nearly all its 100 years and every year during the last 20. Its diverse businesses and leadership in virtually all of them suggest a reasonable basis for forecasting continued steady earnings generation in the future, though that is never free from doubt because of evolving economic environments. With GE's distinguished performance, however, a modest cap rate is perfectly reasonable.
Let's assume GE warrants a risk premium just above the risk- free rate—say, 5%—and apply it to our estimate of average future earnings of about $4.10. An estimate of GE's value can be made simply by dividing the earnings estimate by the cap rate, in other words, $4.10 divided by .05, which equals $82 per share.
If we took a slightly more aggressive guess about GE's earnings prospects, our valuation would look different. Suppose, for example, we forecast the earnings at $5.00. Still using the cap rate of 5% would give us a value per GE share of $100 (5.00/.05). If you go further and deem a lower cap rate of, say, 4% more appropriate given GE's prowess and current business opportunities and conditions, the value per share shoots up to $125 (5.00/.04).
This play with the numbers gives a valuation for GE with a fairly wide range of $82 to $125. The range is broader yet if we take a more pessimistic view. If you use only the average earnings of the past four years of $2.66 and stick with our original discount rate of 5%, the valuation is about $53. If you believe the road ahead is riskier than the road just traveled so that a cap rate of, say, 6% is more suitable, the value becomes $44 per share, generating a "Texas range" from $44 to $125.
The selection of your earnings estimate and discount rate is crucial to this exercise. (A plausible range of values for Amazon.com, for example, starts from zero and goes to a few hundred dollars!) But even if you make those selections ruthlessly, your result cannot be the "answer" to the question of what a share of such stock is "worth." After all, there are plenty of steps in the process where your judgment could turn out to be wrong.
