Thought Experiment

[ohnobananas]

So I've been mulling over this question for a while now.  Probably not applicable in real life but just a thought experiment...

 

Say we've got a public company that, like most other public companies, trades on forward EBITDA and/or earnings.  This company is unique in that previous quarters' financial performance don't have any bearing on future ones.

 

Now my question is, say this company missed both EBITDA and earnings estimates by 100%, as in, they generated $0 in EBITDA and net income.  Would this company's stock price:

1) stay constant

2) drop slightly

3) drop significantly

 

I'm learning towards #1 and #2... I feel like since past financial performance has no effect on future ones for this company and if you measure the stock by forward earnings or intrinsically with a DCF, the stock price should theoretically not move (hence #1).  However, a case can be made for #2 since the company misses out on the forecasted free cash flows, and thus on a NAV-basis, the cash/AR balance is lower by a proportionate amount.

 

What do you guys think?  Also, are there businesses out there that may such characteristics?

[LC]

IMHO totally depends on the business. For example, trulia burnt all their ebitda on marketing and their stock dropped 20%. Other companies with an entrenched position this would not be the case (ie major CPGs)

[RichardGibbons]

It should fall by the amount the owner earnings per share missed.

 

I don't think any such business exists, since the example you gave requires perfect knowledge of the future, which doesn't exist.  I imagine the closest thing to such a business would be a casino or a lottery that has the predicted amount of gamblers, but an unusually large payout.

[gary17]

So I've been mulling over this question for a while now.  Probably not applicable in real life but just a thought experiment...

 

Say we've got a public company that, like most other public companies, trades on forward EBITDA and/or earnings.  This company is unique in that previous quarters' financial performance don't have any bearing on future ones.

 

Now my question is, say this company missed both EBITDA and earnings estimates by 100%, as in, they generated $0 in EBITDA and net income.  Would this company's stock price:

1) stay constant

2) drop slightly

3) drop significantly

 

I'm learning towards #1 and #2... I feel like since past financial performance has no effect on future ones for this company and if you measure the stock by forward earnings or intrinsically with a DCF, the stock price should theoretically not move (hence #1).  However, a case can be made for #2 since the company misses out on the forecasted free cash flows, and thus on a NAV-basis, the cash/AR balance is lower by a proportionate amount.

 

What do you guys think?  Also, are there businesses out there that may such characteristics?

 

are you talking about Fairfax?

[wisdom]

I do not believe the IV would change much as long as the thesis is intact and there is no material change in the business. Mr market may react differently.

[adesigar]

So I've been mulling over this question for a while now.  Probably not applicable in real life but just a thought experiment...

 

Say we've got a public company that, like most other public companies, trades on forward EBITDA and/or earnings.  This company is unique in that previous quarters' financial performance don't have any bearing on future ones.

 

Now my question is, say this company missed both EBITDA and earnings estimates by 100%, as in, they generated $0 in EBITDA and net income.  Would this company's stock price:

1) stay constant

2) drop slightly

3) drop significantly

 

I'm learning towards #1 and #2... I feel like since past financial performance has no effect on future ones for this company and if you measure the stock by forward earnings or intrinsically with a DCF, the stock price should theoretically not move (hence #1).  However, a case can be made for #2 since the company misses out on the forecasted free cash flows, and thus on a NAV-basis, the cash/AR balance is lower by a proportionate amount.

 

What do you guys think?  Also, are there businesses out there that may such characteristics?

 

I would say it would be 3 for me.

If previous quarters have no bearing on future ones we already have very little info to predict future earnings. The info/method that we did use to predict current quarter earnings was flawed since the company missed by 100%. Since the ability to predict forward EBITA/Earnings is gone as shown by the large miss we have to build in a higher margin of safety so the price must drop.

 

The exception to this is if the miss is explained by 1 one time event and I mean a real one time event. Not the kind of one time event that some companies regularly have.

[ni-co]

Say we've got a public company that, like most other public companies, trades on forward EBITDA and/or earnings.  This company is unique in that previous quarters' financial performance don't have any bearing on future ones.

 

Now my question is, say this company missed both EBITDA and earnings estimates by 100%, as in, they generated $0 in EBITDA and net income.  Would this company's stock price:

1) stay constant

2) drop slightly

3) drop significantly

 

I'm learning towards #1 and #2... I feel like since past financial performance has no effect on future ones for this company and if you measure the stock by forward earnings or intrinsically with a DCF, the stock price should theoretically not move (hence #1).  However, a case can be made for #2 since the company misses out on the forecasted free cash flows, and thus on a NAV-basis, the cash/AR balance is lower by a proportionate amount.

 

There seems to be a logic flaw in your assumptions. Either the company needs to reinvest those earnings to keep its earnings power, then future earnings have to be affected by this earnings miss. Or the company can dividend its earnings out, then the excess cash on the balance sheet is additional value, in other words: then the company's share price reflects not solely forward earnings, but also the excess cash. In both scenarios, the earnings miss has to affect the share price.

 

How much the share price is affected depends on how much the earnings power/cash account is affected. You can't say that this generally has to be significant or insignificant for the share price.

[ni-co]

To make it completely clear:

 

Say we've got a public company that, like most other public companies, trades on forward EBITDA and/or earnings.  This company is unique in that previous quarters' financial performance don't have any bearing on future ones.

 

and

 

…since past financial performance has no effect on future ones for this company…

 

…can't be true at the same time. If the company's previous quarters have no effect whatsoever on future ones, the price does not only reflect future quarters but also excess cash earned in past quarters. It has to drop by the amount of the earnings miss, as shareholders won't get this dividend.

[Guest deepValue]

To make it completely clear:

 

Say we've got a public company that, like most other public companies, trades on forward EBITDA and/or earnings.  This company is unique in that previous quarters' financial performance don't have any bearing on future ones.

 

and

 

…since past financial performance has no effect on future ones for this company…

 

…can't be true at the same time. If the company's previous quarters have no effect whatsoever on future ones, the price does not only reflect future quarters but also excess cash earned in past quarters. It has to drop by the amount of the earnings miss, as shareholders won't get this dividend.

 

He didn't say past performance has no bearing on the price, he said it has no bearing on future financial performance. i.e. future earnings.

 

Regarding the original post:

 

I don't entirely understand what you're trying to get at in this thought experiment. The value of the company would fall slightly because it missed out on a quarter's worth of earnings. In an efficient market, #2 would occur (assuming future earnings are expected to be sufficiently large in relation to last quarter's expected earnings that never materialized).

 

So, you're basically asking if there are any stocks that missed earnings estimates last quarter but will perform better in future quarters. That could be a lot of companies; just go down a list of companies that missed estimates last quarter and see if any look attractive. You might start with Coca-Cola and PepsiCo.

[ni-co]

 

He didn't say past performance has no bearing on the price, he said it has no bearing on future financial performance. i.e. future earnings.

 

 

I didn't say that, but that's beside the point. I think we are talking about the same thing:

 

If one quarter's earnings have no relevance for subsequent earnings, an earnings miss won't affect the earnings power of the company. In other words, this hypothetical company can dividend out its earnings completely while keeping its economic size. In this simple case, the value of this company is exactly the sum of all of the future discounted earnings PLUS any excess cash on the balance sheet. If this hypothetical company misses one quarter completely, its value is reduced by this earnings miss (i.e. this quarter's earnings) only. Hence 2) is correct.

 

in an efficient market, 1) can never be the right answer and 3) can't be true, unless future earnings were affected by the earnings miss (which, by definition, they are not).

[Ross812]

So I've been mulling over this question for a while now.  Probably not applicable in real life but just a thought experiment...

 

Say we've got a public company that, like most other public companies, trades on forward EBITDA and/or earnings.  This company is unique in that previous quarters' financial performance don't have any bearing on future ones.

 

Now my question is, say this company missed both EBITDA and earnings estimates by 100%, as in, they generated $0 in EBITDA and net income.  Would this company's stock price:

1) stay constant

2) drop slightly

3) drop significantly

 

I'm learning towards #1 and #2... I feel like since past financial performance has no effect on future ones for this company and if you measure the stock by forward earnings or intrinsically with a DCF, the stock price should theoretically not move (hence #1).  However, a case can be made for #2 since the company misses out on the forecasted free cash flows, and thus on a NAV-basis, the cash/AR balance is lower by a proportionate amount.

 

What do you guys think?  Also, are there businesses out there that may such characteristics?

 

The market would react by 2 or 3 depending on the situation. I'm thinking of an insurance company, say Lancashire. If they had a bad catastrophe and paid their entire quarter of earnings to cover the cat, their stock price would absolutely go down. I'm basing this on the last half of the year when we saw good underwriting and an acquisition that was a one off event that lowered earnings and should actually enhance them in the future. The stock price fell by over 10%.   

[SharperDingaan]

3) & drop like a brick.

 

The evidence points to zero predictabiity & that most of everything 'known' about this company may well in fact be false. You have no idea what it may be worth, & as a result - would be reluctant to pay much above the discounted liquidation value of its assets or holdings.

 

SD