Streetwise

Lauren Rudd

Sunday, June 26, 2011

The Key Is GAAP Earnings

If concerns over possible tax increases, the deficit, inflation and potentially higher interest rates are clouding your investment outlook, you are not alone. Therefore, let me see if I can add a bit of clarity, while at the same time stripping away the emotional aspects of these issues.

The current deficit is not a slippery slope to an upward inflationary price spiral. Two key reasons are the lack of wage pressure and the lack of consumer demand. Furthermore, a study by University of Chicago professor Casey Mulligan concluded that inflation rates and government spending are only weakly correlated.

Yes, the Fed did reaffirm its position of continuing to keep the Fed funds rate at its current low level. However, long term rates are market driven and subject to the vagaries of supply and demand. Yet, we have not seen any dramatic increase there.

So, despite what some politicians would have you believe, the world is not coming to an end. However, that does not mean that everything is coming up roses. In 1940, Fred Schwed, Jr., penned the book, “Where Are the Customers’ Yachts.”

The unfortunate truth is that most investors do not have yachts...or even rowboats. The primary reason is a penchant to be swayed by tales comprised mostly of fool’s gold. Consider the recent initial public offering of Pandora Media.

Two days after Pandora's stock debuted it had handed back all its gains and was down nearly 20 percent from its IPO price of $16. That means anyone who bought shares at the IPO price or higher is likely suffering. And so it should be, not due to Schadenfreude on my part but because it demonstrates that there remains some degree understanding within the markets as to what really constitutes value.

And Pandora’s performance is not a unique. It just so happens that the online music provider’s rise and fall occurred quite rapidly. Shares of LinkedIn and China's Renren, both social network companies that debuted in May, also reversed course after strong debuts. It just took them a bit longer. Today, LinkedIn is still above its IPO price but is down 45 percent from its high, while Renren is down 70 percent from its IPO high.

For the Chinese Internet companies there has been a double dose of bad news. A series of accounting scandals at Chinese companies listed in North America has led to a loss of confidence in the sector generally.

However, if you still feel that you missed the boat or that Pandora was a fluke, you are going to have another chance or two. Groupon has filed for an IPO, while Zynga and Twitter could also announce IPO plans before long. Yet, Facebook is the most anticipated IPO, considering it has 500 million users and this year could produce what one researcher estimated would be $4 billion in ad revenue.

My greatest concern with companies like Groupon and others of its ilk is a lack of profitability. Groupon announced an operating loss of $117 million in the first three months of the year. In its IPO filing, Chief Executive Andrew Mason said the company does not value itself in a conventional manner and suggests other ways of looking at how much Groupon is worth.

Nuts, the key to the analysis of every company is first and foremost good old fashioned GAAP earnings and then intrinsic value by whatever method you wish to use, free cash flow to the firm, discounted earnings or some version of a dividend discount model.

Pandora has never turned an annual profit. So will Pandora serve as a lesson to super-hyped start-ups and those investors willing to overlook doubtful business plans to get a piece of the action. I sincerely doubt it. The greed factor is just too overwhelming.

Maybe from the perspective of a company and its underwriters the rush to sell shares to the public and raise money is sensible, given that they can play on the uncertainty surrounds the housing markets, employment and fears regarding inflation.